• Stuart Fowler

2009 Spring Budget

This was a deeply depressing budget, not so much because of the bleak economic context but because of the sense that, far from rising to the challenge, the Government is sinking into incoherence, inconsistency and irrelevance. We cannot remember a similar mood amongst professional advisers (not particularly prone to political bias) of despair and disdain.

Within this page we single out three key areas that are of particular importance for private clients:

  • The Treasury’s unrealistic economic forecasts, their projections for public borrowing and the implications for the chance of a funding and/or sterling crisis

  • The flawed economics and negative, regressive politics of a 50% top rate of tax

  • The particular implications for pension planning of another attack on pensions for the wealthy

As is our custom when writing about budgets, we focus on the policy implications rather than itemise the details. You will probably have these already from your accountant or the press but do not forget HMRC itself.

Class politics This is clearly a political budget, more Brownian than Darling, but the tactical thinking is not so clear and how it will play on the street is also open to question.

  • It presumably means to be about equitable sharing of the burden of adjustment to harsh times but it also comes across as pressing ancient Labour buttons that assume an economic class enemy.

  • At a time when economic realism seems to be the order of the day, it appears to lack realism.

  • As a basis of a fourth-term Labour manifesto, it is difficult to see it as anything other than a declaration of internal warfare.

  • As a message to the public about what the Government stands for, it confirms the impression (given, for instance, by the McBride emails) of a dysfunctional administration obsessed with form not substance and too out of touch to realise who is making a fool of whom

We could, of course, have been equally disparaging of a tired Conservative administration in 1997. Democratic politics, like financial markets, appear to have their own systematic and irresistible dynamics.

Labour’s tactics look like a gift to the opposition parties. It is an opportunity to paint a more plausible and modern route out of austerity, led by enterprise, as the only source of wealth creation, and necessarily therefore requiring enterprising people as well as properly organised structures for managing and regulating business.

The same principles of business management, more technical than radical, will need to be applied to public-sector business management if they are to look plausible as an alternative to New Labour’s unsuccessful sequence of often conflicting initiatives for running public services.

The antithesis of dysfunctional is functioning. It remains to be seen whether this antithesis is credible as an electoral strategy and will play well in ‘the middle ground’. It may not look very likely now, when people are still busy looking for scapegoats, but this will change.

Old class war divisions will also fail to resonate if any sense of inequity about the sharing of the burden of economic adjustment originates much more in a different division, between private- and public-sector employees. Whoever is in government is going to need to address this division as part of dealing with the structural imbalance in public finances. Their task will be much easier if it is actually dividing public opinion as well.

Prudence moves out as Rosy Scenario moves in The Budget forecast of a fall in GDP of 3.5% this year is not massively better than private forecasts although it was embarrassing for the Government that the latest quarterly numbers (albeit it will be subject to lots of revisions later), released in the same week as the Budget, left the 3.5% forecast high and dry. More important, the central assumption in this Budget of a recovery starting by year end and reaching 3.5% pa from 2011 definitely is massively better than most forecasts.

The Budget never is a stress test but clients might reasonably wonder whether the public finances, like their own finances, should be planned with the benefit of realistic estimates both of how good it can be and of how bad it can get.

Even in this rosy scenario of a swift and strong recovery, the outlook for public finances is dire. The forecast rise in net public-sector net debt from 59% this year to 79% of GDP by 2013/14 is completely outside peace-time experience. Public spending as a share of national income will break outside the 40-45% share that represents the post-war consensus of a mixed economy. On Treasury forecasts it will peak at just below 49%, similar to the level that saw Labour turned out and Thatcher’s Conservatives given their chance. On private forecasts that assume a slower recovery, the public spending proportion will exceed 50%.

The Treasury’s projections for net debt include an expected benefit from private-sector income and expenditure growing faster than public spending after this one terrible year. Since the pre-crisis public spending plans have not been cut very much, this is tantamount to assuming that the rebalancing of personal and company balance sheets, the mirror image of the over-spending and over-borrowing that got us into this pickle, need not occur.

Not only does balance sheet rebalancing need to occur but it would be extraordinary if it does not. With access to credit no longer something to take for granted and unemployment rising rapidly, balance sheet decisions will surely be driven by rebuilding liquid savings. As we have pointed out many times, the first effects of this are frustrated by everyone attempting to do the same thing at the same time, hence increasing the need to draw on, rather rebuild, liquidity.

Why the optimism? The only firm foundation for the Government’s optimism is the same factor driving equities higher at the moment: the inventory cycle. When businesses first sensed the possible problems obtaining credit to finance an increase in working capital, as final sales started to nose-dive, their swift response was to cut both output and costs, and to cut deeper and faster than in living memory. This pushed the financing problems down the supply chain, also with unprecedented speed. It is reflected in the severity of the falls in GDP in the major manufacturing economies.

These perverse first effects may just have worked their way through the system to the extent that some restocking is already taking place, boosting final sales (and, if there is to be more life in it, purchasing orders). Even if it is happening, do not confuse this with the end of the recession. The profile of this recession will be a function of balance sheet rebuilding not the traditional inventory cycle.

At the same time consumer spending in the UK (as in the US) is holding up reasonably well, even if there are switches within the household budget. But this is also no basis for sustained growth if it is merely denial about the need to improve household finances. If so, when the inventory support falls away the Chancellor’s rosy scenario will go the way of all his other forecasts.

Trying to relate the shifting opinions about the economy to the changing level and momentum of the stock market is essentially flawed as an investment approach, as we have many times argued. All the evidence is that market timing is not a skill the industry can and should rely on, possibly in part because the expected link with contemporaneous economic indicators is actually very weak.

Funding crisis Necessarily, the public finances will have to balance any shortfall against growth forecasts, in which case borrowing will rise even further. But the possibility that public finances will be even worse than the Treasury assumptions does not mean a crisis funding public debt is more likely, as the conditions leading to an even worse borrowing requirement might be the same as those in which savers prefer to lend to the Government than spend or lend to private borrowers.

However, this does not apply to foreign holders of sterling debt, as they also have to consider the exchange rate risk, or hedging costs (set by market views of the exchange rate risk). Being in the same boat as other governments is not much comfort if we have a few differences in our situation that matter a lot to foreigners. For instance, we have a history, reconfirmed in the past year, of using competitive devaluations to solve short-term problems with our trade account. We also have a much higher structural imbalance in public finances, now that we can see that the exceptionally large contribution of the financial sector to tax revenues was illusory (taxing profits that were not accounting fictions) and unsustainable (regulatory policies and market constraints on the provision of new banking capital will ensure a smaller financial sector in the future).

As highlighted in our recent paper on currencies, the risks for sterling also have to be seen in the context of a set of other risks specific to the euro zone and the dollar. So we ought not to assume too glibly that sterling will either rise or fall, whereas we probably ought to assume the recent dramatic increase in currency volatility will persist.

Expensive capital From both a domestic and foreign perspective, the state of public finances increases the chance that sterling capital costs will, in real terms, be very high over much of the coming decade. This conflicts with short-term expectations that weak spending and investment and unparalleled monetary stimulus will combine to keep inflation very low or even, as for several months already, slightly negative. The same conflicting views apply to the global outlook, not just the UK. In many versions, it is only as economies start to recover that the increase in capital costs is expected to arise. But in other versions, the rise occurs much quicker, either as a consequence of a funding crisis or because the economy is so dire that deflation causes real interest rates to soar.

A high real cost of capital has negative implications for the ‘real economy’ (depressing investment) and for the prices of the major portfolio investments: bonds, equities and commercial property. It is a killer for house prices as it keeps up the financial pressure to liquidate stock and reduce bids even after sanity has returned to valuation levels.

New higher tax rate The Government is bringing forward by one year the planned new tax band of 45% on incomes above £150,000 and increasing it to 50%. In addition, where income exceeds £100,000 there will be a reduction of the personal allowance by a factor of £1 for every £2 on the excess.

Taxing high earners plays well with traditional Labour supporters and may also serve to balance the impacts of the recession on lower-income households but the marginal rate of tax of 60%, caused by the reduction in the personal allowance on incomes above £100,000 is biting awfully close to middle England and will involve a much larger number of taxpayers.

The political capital at stake in taxing the wealthy more heavily probably dominates the economic benefits. The Treasury estimates this will raise £2b pa but the Institute for Fiscal Studies believes tax revenues in the 1% of the taxpayer population with incomes over £150,000 are probably maximised at the current rate of 40% because of the impacts on spending decisions and indirect taxes. The margin of error is very high given that the gross increase in revenues, if there was no offsetting loss of revenue through behavioural responses, is £7.5b even on the Treasury forecasts so no net benefit is the difference between offsetting effects of say £5.5b or £8b. The Treasury, incidentally, believes the tax take on that income bracket is maximised at around 55%.

We cannot rely on past experience as too much has changed. During the unusually long period in which the top rate remained stable at 40%, indirect taxes and National Insurance have increased so 50% may be more comparable with 60%.

What else has changed is Labour’s ‘kettling’ tactic of closing off, over a series of budgets, the traditional routes for sheltering high income: pensions and venture capital. That leaves just two escape routes and we are left guessing how much they will be used and the impact on revenue raising.

  1. Selling up: business owners can convert their future income streams taxable at 50% to capital gains taxable at 18% (or even, for a lifetime allowance of £1m, 10%)

  2. Leaving the UK: and not necessarily to live in tax havens since few countries rival our total tax burden on the rich and those that do get away with it because they deliver value for taxpayers’ money

The tax increase also affects the willingness of international employers to site or expand operations in the UK that require high-earning employees.

Guessing the impact of a 50% rate also requires a view on how attitudes will harden if the economy deteriorates. This always applied anyway to non-doms, if their location was driven as much by business as personal choice. The most potent threat is possibly not from people leaving but from people who might leave fearing they may not being able to take their capital with them. This could only happen with the reimposition of exchange controls and that is only conceivable in the event of a major funding crisis associated with a collapse in sterling. This is the sort of small-probability event with big consequences rational people seek to insure against.

Pension changes

Sup with a long spoon I’m sure our clients will not be surprised, let alone shocked, that the A-Day pension ‘simplification’ changes only lasted three years. In fact, the Budget attack on both pension contributions and high rates of capital extraction that would attract income tax at 50% is the second change of heart. The Government had already decided to freeze the Lifetime Allowance for at least five years, instead of implementing the planned annual increases that were announced when the simplification was introduced. This was to prevent high earners escaping the introduction of the planned 45% tax rate.

The Lifetime Allowance was by nature an absurdity because of the impact of uncertain investment returns. High returns or lack of full indexation of the allowance for inflation could cause a breach and penal tax charges. But tinkering with the Allowance for short-term expediency makes it virtually impossible to plan contributions rationally.

The Budget changes are intended to remove tax breaks for large contributions made by high earners. They apply to both personal pensions and employer contributions to either personal and occupational (final salary) schemes, including arrangements known as ‘salary sacrifice’. We will explain the detail in a later email or paper once we have clarification of some internal contradictions. It seems likely further HMRC notes will be needed.

The general impact of the changes is nonetheless clear: it is irrational to make large pension contributions. The changes send two clear signal to actual or aspiring high earners:

  • Governments cannot be trusted to keep to the implicit contract, based on underlying economics that have merit for both parties, involved in pension saving (we explain the contract in a separate section below)

  • This Government will penalise economic success.

  • Important though these signals may be in a poorly-informed market, the fact is that the introduction of the A-Day Lifetime Allowance had already capped the economically-sensible level of lifetime contributions, whether in personal or occupational pension schemes. The only change this Budget makes is to make it rational to spread lifetime contributions rather than make them in a lumpy fashion.

From a planning point of view that is not a trivial change as some high earners will have assumed that they can make large contributions up to the safe level (allowing for investment growth) in the latter stages of their career. This aspect of the implied contract has been wilfully broken.

The after-tax benefits of investing in and out of a pension wrapper We were unusual amongst advisers, even before the Budget changes, in viewing the net present value of the post-tax payment streams from pension and non-pension investment as finely balanced. Many advisers, as well as many individuals, are quick to value the tax credit going in and the tax-free roll-up in a pension scheme but ignore the fact that they then expose 75% of the eventual extraction of pension value to top rates of income tax (ie assuming the tax free cash proportion is 25%). This is not necessarily ignorance and could be bias: only the bits of information are given to clients that encourage the sale of products or increments to assets under a portfolio fee or trail commission arrangement.

Even when advisers can calculate both post-tax ‘income’ streams correctly, there is a tendency to overlook the chance that full value of a pension fund will never be extracted in the lifetimes of the member and spouse and that, assuming no annuity purchase, some element of the value will be lost to the penal charge on inter-generational transfer of the pension residue, or undrawn capital at death.

The comparison is also sensitive to the assets held. Because a high proportion of mature funds managed by No Monkey Business will be held in index linked gilts, almost regardless of differences in risk tolerance, and because index linked gilts are very tax-efficient when owned directly rather than through a tax-favoured wrapper, the tax advantage of a pension wrapper in drawdown is much less than in accumulation, when risky assets are likely to be a larger part of the portfolio.

Three tax changes announced in this Budget, restricted to high earners, affect this comparison between pension and non-pension:

  • Tax relief on contributions over £150,000 after 2011 will be tapered down to the basic rate at £180,000

  • The Government is proposing to tax employer contributions, either to final-salary schemes or personal pensions, as benefits in kind (presumably intended to undermine use of ‘salary sacrifice’ arrangements as a way of reducing the impact of the loss of higher-rate relief at the margin); it is the practical issues in a final-salary scheme of quantifying the chargeable amount on which to base this that require an interim period of two years rather than making all the changes effective immediately

  • High rates of drawdown, such as when a strategy of maximum capital extraction is being pursued from a large fund (irrespective of spending targets), will tend to increase exposure to the new top rate of income tax of 50%.


The HMRC Budget notes go well beyond the Chancellor’s Budget speech. The Government is acting to prevent those earning more than £150,000 from making the most of their higher rate tax relief before it is removed in 2011 by bringing forward the tax change on irregular contributions over £20,000 a year.

From April 2011 the higher rate tax relief of 40% for those earning more than £150,000 will be tapered down to 20%. In anticipation of large numbers of higher earners rushing to contribute to their pensions before 2011, the Government has said that if people change their normal pattern of contributions to pay more than £20,000 a year into their pension they will lose their entitlement to claim higher rate tax relief on regular contributions during this period.

‘Where regular pension savings exceed £20,000, the new tax charge applies to any pension savings made on or after 22 April 2009 in excess of regular savings,’ the HMRC said. ‘Where regular pension savings are below £20,000, the tax charge applies to any excess over £20,000. The charge has the effect of restricting tax relief on the additional pension savings to basic rate.’ It remains to be seen whether a particularly vindictive definition of ‘regular’ which excludes annual contributions (such as typically made by partners, such as lawyers) will make it to the statute book.

HMRC also indicated that advisers could also be liable if they advise their clients to take advantage of the higher rate tax relief before it is removed. ‘HMRC will look very closely at all arrangements designed to avoid the tax,’ it said. ‘We will pursue any such arrangements vigorously and apply the full breadth of sanctions allowed under the law.’ Better be careful, then.

Drawdown A noted above, the practical impact of these measures on high earners is small because of the overarching purpose of the Lifetime Allowance. Not so the impact on high earners already in drawdown from their pension plans. Clients in drawdown who, we have previously advised, stand to maximise their eventual capital extraction rate from their personal pensions by drawing the maximum permitted rates now face an unexpected obstacle in the form of exposure to a 50% marginal rate of income tax instead of 40% (rising to 45% in two years).

This 10% loss of benefit, or value, needs to be compared with the potential loss of value resulting from the failure to extract all of the capital from the pension fund. This is a tricky calculation, subject to the maths of ‘joint probabilities’.

Under personal pension rules, the risk of failure to extract capital is quite significant, and indeed a loss of value for most long-lived pensioners is almost inevitable, unless an annuity is purchased and the annuitant outlives their expected longevity. This is because the maximum draw after age 75 assumes that the pensioner’s age remains fixed at 75, even if the actual age is, for instance, 90. We assume the purpose of this was to appear to be caving in to pressure to give people the freedom not to buy an annuity but then take it back by making it economically irrational to exercise that freedom.

An alternative arrangement (which may not survive future reforms) is to transfer clients to pensions written under ‘scheme rules’, such that the drawdown after age 75 is based on actuarial assessment of the adequacy of the fund, based on actual age attained. Assuming normal life expectancy, close to full value should then be obtained.

Assuming the probabilities specific to drawdown under scheme rules, the chance of failing to obtain full value through early death (post vesting) of both member and spouse, giving rise to a penal tax charge on the residual capital passed to the next generation, is small but significant enough, we felt, to warrant a strategy of drawing at a rate in excess of the spending targets, and drawing from pension assets as a priority over non-pension assets. This may no longer be the case at a 50% tax rate. If we knew it were temporary, it would certainly be sensible to stay within the 40% band.

The income tax impact of bringing drawdown forward can be partially mitigated by IHT savings, by establishing a pattern of gifts out of income, as part of planning inter-generational wealth transfer. This also now has to withstand a tax rate of 50% although IHT may itself be increased above 40% in later budgets.

We will advise drawdown clients individually of any need to review their drawdown rates in the light of these changes.

The pension contract between government and the people The objective of the contract, however constructed in detail, is to encourage provision (through ‘funding’, which involves actual saving and investment) for people’s retirement spending. Traditionally, the form of the contract in the UK has been tax incentives going in, during accumulation and then recovery of the incentives when the pension income is eventually received. The underlying economics therefore involve temporary subsidy, via deferment of tax.

This is affectively a transfer to the current generation of tax payers from a later generation. Such a transfer needs its own reward or return to be equitable (though equity is not necessarily the principle of inter-generational transfers when governments are involved). This economic value added comes from the expected real growth, in excess of the real time value of money, of the ‘accumulation funds’, because of the way they are invested in risky assets that over long horizons should earn a risk premium. That economic value added is captured via the tax on a larger accumulated sum, collected as income tax on the cash stream generated by the larger capital sum. It is converted to ‘income’ either via an annuity (at a fixed conversion rate on one, possibly one single day) or over many dates via the mechanism of drawdown.

As noted above, the particular mathematics that allow the terms to be valued are comparisons of the discounted net present values of two streams, after the tax appropriate to each stream: inside a pension wrapper and outside a pension wrapper. For wealthy individuals, we can assume ‘must use’ wrapper capacity such as ISAs will be used for some purpose, if not retirement income, so it is the tax treatment of ‘direct’ investment that is best compared with pension accounts.

The streams in each case involve three stages: income in, growth in accumulation (from investment ‘total return’) and income out.

Uncertainty about changes in tax rates between the accumulation and drawdown phases of a pension have always been part of the implied contract between government and the people. The increase in the marginal tax rate on high levels of pension income is not therefore fundamentally unfair.

The uncertainty has always been best managed by flexible arrangements for taking pension benefits, as in drawdown, rather than inflexible arrangements like an annuity. The value of managing the timing of income payments is greatly increased by higher marginal tax rates.

In practice, the maths only work for the individual on almost all assumptions for the uncertain variables if the tax rate in drawdown is lower than the tax rate in accumulation. These are not likely to be the individuals affected by the increase in top rates (although, as our clients know, it is possible to bring wealthy individuals below the top-rate threshold if they have not already made heavy use of pension accounts). For clients with high average tax rates before and after vesting, the contract does not make sense on all assumptions for the variables and so is much more marginal. Note that it certainly would not be rational if tax free cash were to be interfered with. In a budget where many feared it would also be tinkered with, it has remained unscathed.

This mathematical approach ignores other ‘soft’ factors such as flexibility and balance which will always call for a mix of pension and non-pension capital to fund retirement spending.

Investment bonds An unfortunate side effect of making pensions less attractive is that many advisers will feel it is now easier to sell one of the most profitable and conflicted products on the market: insurance-company investment bonds.

Offshore bonds are issued by life companies that operate in low-tax or zero-tax areas so the company itself is not taxed, in the way that onshore life insurance companies are. Offshore bonds are popular because they provide tax-free roll-up of income and gains within the fund in the same way as in a pension (or ISA) wrapper. Brokers tend to overvalue the flexibility to realise gains without an immediate CGT charge because of their bias to active management. (Remove the bias and other tax-favoured wrappers, pension accounts and ISAs, are likely to be able to hold enough risky assets to meet any portfolio rebalancing needs tax-free; unwrapped holdings should then be a passive mix of trackers.)

When the bond is sold, any realised gain over the initial capital (on withdrawals in excess of 5% pa of the original capital) is subject to income tax at the investor’s marginal rate. Brokers often misrepresent both the 5% pa return of capital and the CGT avoidance as a tax saving but in fact it i) defers the tax and ii) converts it from gain to income. It requires an assumption of a drop in marginal tax rates to the basic level (or to escape tax by becoming non-resident) when the gains are realised to justify the choice of a bond. Even that still leaves a broker struggling if required to justify the additional costs of the product.

In our experience, there are very few cases where an investment bond is a suitable solution and we are very disappointed to see changes in taxation that will encourage their misuse.



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