Pensions post PBR
No Monkey Business has consistently maintained that governments, and indeed financial advisers, exaggerate the lifetime tax benefits of pension savings. This is not to do with the argument about whether they should be providing this form of savings incentive in the first place. It is just about valuing the incentive itself.
We have sometimes asked people, as a simple exercise, to consider whether they could come up with a form of tax subsidy to accumulators that would be recovered (with interest) when benefits are taken, so that there is only a loan from one generation of taxpayers to another. Obviously, this is not a difficult concept in theory, although the numbers would have to be right to ensure no net shift of economic advantage between the generations. The point we wanted to make was that we reckoned that the numbers since the 2006 reforms were just about right to make it generation-neutral.
The 2009 Budget restrictions to higher-rate tax relief on large contributions, now extended in this PBR from money purchase to defined benefit employer contributions, tilted the balance decisively against pensions for high earners. Not only is the relief going in restricted but it is now likely to be below the average rate at which benefits are taxed, so when the ‘growth dividend’ on tax-free accumulation is added (the way ‘interest’ is taken by the generation making the loan) the present value of the entire stream, in and out, is now likely to be greater out of than in a pension.
In our comment on the 2009 Budget we suggested the change to relief going in was likely to be academic in practice because of the earlier introduction of the lifetime allowance. This was the measure (dating back to 2006) that put a limit on the amount of this ‘time shift’ activity between generations of tax payers.
For anyone not doing the pension maths from start to finish, it was likely to be the allowance that would stop them making suboptimal decisions about pension funding, since most individuals, accountants and financial advisers assume pension contributions should be maximised for reliefs, not lifetime present values on assumptions about uncertain rates of capital extraction. Calculations should not ignore the uncertainty about the amount of capital that can be enjoyed either as lifetime spending or as a bequest. This is a serious oversight as there is in practice a large degree of inefficiency in the extraction of value from a pension account under current tax rules, arising from the combination of extraction limits and penal taxation of residual funds after the death of the member (and spouse).
The extension of the relief restriction to defined benefit schemes is logical in terms of the fairness principle the Government has chosen to use as justification, if applied to equal treatment of the two types of scheme. However, the claim it makes about fairness in terms of the benefits received, suggesting high earners benefit disproportionately, is not exactly honest because it makes the same ‘mistake’ of ignoring the growth dividend and the lifetime and death taxes on benefits.
However, extending the regime to defined benefit schemes poses many practical problems on which the Treasury now finds it necessary to consult. Not least, there is no obviously correct or superior way to calculate the quantum of the benefit in kind when employers make regular scheme funding contributions to match the individual accrual of benefits by employees.
The problems will only arise for individuals earning in excess of £130,000 not including the value (to be determined) of their employer pension contributions. For those over this threshold, the rate restriction will taper between earnings including employer contributions of £150,000 and £180,000, down to 20% at the top end.