The two most discussed reforms of pensions tax relief, removing the higher rate of relief and introducing a new single rate of relief at 25% would not significantly improve the retirement income of lower and median earners but would result in reduced pension income for millions of others who pay higher rate income tax, most of whom are already not saving enough for retirement, according to new analysis by the Pensions and Lifetime Savings Association (PLSA).
During the past year, there has been much speculation in the media that the Government may be looking at reforming pensions tax relief as a source of additional revenue to help pay for the costs of the pandemic or to support the cost of changes to social care.
In a report published today, ‘Pension Tax Reform: Implications for Savers’, the PLSA explores how a selection of workers with different levels of income and in different types of workplace pension scheme would be affected by four potential reform options. These include flat rate relief set at 20%, 25% and 30%, and TEE – whereby pension contributions are taxed at a person’s marginal rate of income tax but investment returns and pension income are exempt.
The report shows the effect on private pension income, total retirement income, retirement replacement rates and the PLSA’s Retirement Living Standards.
The analysis, based on modelling by the Pensions Policy Institute (PPI), finds that removal of the higher rate of pensions tax relief would be of no benefit to the majority of taxpayers who pay Basic Rate income tax and even the introduction of a new, more generous, single rate of 25% would only result in a modest uplift in pension income for some savers.
Basic Rate Taxpayer / Median Earner
If higher rate tax relief was removed and everyone received a single rate of relief at 20%, a person on median earnings throughout their working life (i.e., at age 22 earning £19,000 per year and at age 68 earning £29,000 per year) would see no change to their pension contributions or tax bill.
The same person, however, would see an increase in their private pension income due to a rate of tax relief of 25%. This would result in a higher pension of between 5% and 8% depending on the type of scheme they are in. For someone saving at the 8% minimum AE level the additional annual income in retirement would be around £200 per year.
However, despite this higher private pension income, when the person’s overall replacement rate from both their state and private pension income is taken into account, the application of tax relief at 25% would result in only a very small increase in pension income. Under the current system they could expect to receive a replacement rate of 52% and under a single rate of 25% they could expect to receive 53%.
IMPACT OF DIFFERENT TAX REFORMS ON A MEDIAN EARNER’S AVERAGE TOTAL RETIREMENT INCOME AND THE RETIREMENT LIVING STANDARD ACHIEVED
Higher Rate Taxpayer – 90th Percentile Earner
All higher rate taxpayers would pay more tax for every year that they remain a higher rate taxpayer. For some, particularly those in DB schemes, there would be very substantial tax bills to pay and, for their schemes, a decision to make as to whether to allow the tax bills to be paid by the scheme in return for lower benefits at retirement.
Under a reform where all the higher rate of tax relief is removed (a 20% single rate), someone who remains a 90th percentile earner throughout their working life (i.e. at age 22 earning £29,000 per year and at age 68 earning £64,000 per year), would pay between £34,500 and £205,700 in extra tax over a working lifetime, depending on whether saving into a DC scheme at the 8% minimum AE rate or in a typical DB CARE scheme such as that used in the NHS. The resulting reduced pension contributions would lead to the high earner’s retirement income falling by between £900 per year and £7,500 per year, depending on the type of scheme. This amounts to a reduction in private pension income of over 20% in all scheme types.
If a single rate of tax relief at 25% is introduced, the same person would also lose out, though less than is the case if all higher rate tax relief is removed. At this rate, a 90th percentile earner would pay between £26,300 and £150,400 in additional tax, depending on whether the person is saving in a DC scheme at the minimum AE level or in a typical DB CARE scheme. This results in a reduction in private pension income of 16%.
If we consider this person’s overall replacement rate from both the state pension and private pensions, if all Higher Rate tax relief is removed (i.e., a 20% rate is used) and the person is saving at the 8% AE minimum in a DC scheme their replacement rate will fall from 33% under the current system to 31%. If the person is saving in a typical DB CARE scheme, the replacement rate will fall from 115% to 110%. If a single rate of tax relief of 25% is adopted they have very similar outcomes.
The PLSA found in its previous paper, ‘Five Principles for Pensions Taxation’ (first published in February 2021), that adopting a single rate of 25% might be expected to raise £3.5bn-4.8bn per year for the Treasury. Removal of all higher rate relief, i.e., adopting 20% for pensions tax relief, would raise around £8bn to £10bn per year. However, these savings for the Treasury would result in lower pensions for many.
The modelling also demonstrates how few people are currently likely to achieve a ‘Moderate’ or ‘Comfortable’ Retirement Living Standard from pensions. All but high earners, 90th percentile earners in a generous DB scheme or some of those making very large DC contributions throughout large part of their career, get near the ‘Comfortable’ level. Under current minimum automatic enrolment savings levels of 8%, people on median earnings saving by themselves are only likely to achieve somewhere between the ‘Minimum’ and ‘Moderate’.
IMPACT OF DIFFERENT TAX REFORMS ON A 90th PERCENTILE EARNER’S AVERAGE TOTAL RETIREMENT INCOME AND THE RETIREMENT LIVING STANDARD ACHIEVED
Alongside our report ‘Pension Tax Reforms: Implications for Savers’ we have today also published an updated version of our ‘Five Principles for Pension Taxation’ report, first published in February. This new report extends the assessment of how pension reforms do, or do not, meet the PLSA’s Five Principles, by assessing three further commonly proposed reforms.
Nigel Peaple, Director of Policy and Advocacy, PLSA said: “Many commentators talk about the desirability of pensions tax relief reform, particularly the idea of removing Higher Rate pensions tax relief or introducing a new Single Rate of 25%. However, our analysis shows that such reforms create few winners and many losers.
“Under the worst scenario assessed by the PLSA, a person who pays the higher rate of income tax for almost all of their working life could see a reduction of over 20% in their private pension income before tax, irrespective of the type of scheme they belong to.
“While it might seem reasonable to reduce tax relief for the 13% of the working population who pay higher rate income tax, it should be remembered that many more than 13% of taxpayers will earn this amount at some time, and many only for a short number of years towards the end of their careers – when pension saving is often at its highest.
“The PLSA estimates that the removal of higher rate tax relief on pension contributions could result in around 3-4 million taxpayers each paying an average of £2,000 more tax each year; money that would otherwise have gone into their pensions.
“On balance, the PLSA believes the current system of pension taxation should be maintained to encourage an adequate level of saving for all. However, if the Government does choose to introduce a reform, we urge them to consider the ‘Five Principles for Pensions Taxation’ that we set out earlier this year, and to consult extensively to avoid unintended consequences.
“The difficulty in achieving adequate levels of income in retirement set out in our report, highlights the case for increasing the statutory minimum under automatic enrolment pension saving, not taking actions that result in less saving.”
NOTES TO EDITORS
The ‘Five Principles for Pension Taxation’ discussion paper sets out the principles on which any reform of pension taxation should be based and assesses the impact of a set of major reform options on savings, savers, and schemes.
Five Principles for Pension Taxation
• Promotes adequacy: provides financial support and incentivises saving for retirement.
• Encourages the right behaviours: helps savers make the right decisions about retirement saving.
• Fair: helps everyone – the employed and the self-employed - save for retirement.
• Simple to adopt & administer: avoids unreasonable transition and on-going costs for employers and schemes.
• Enduring & sustainable: designed to avoid repeated change and so builds confidence in long-term saving.
First published in February, the report assesses the principles against reform options including setting tax relief at a single rate of 20%, 25% and 30%, reducing the annual allowance and the lifetime allowance and adopting a TEE system.
Today’s second edition adds assessments against three additional reform options: removing National Insurance relief on employer contributions, capping the tax free lump sum at £75,000 and splitting the DB and DC regime.
Our assessment suggests that no single reform or the current system is perfect. Most reform options leave many people with lower pension savings and create very substantial cost and complexity for employers and occupational pension schemes.
Mark Smith, Senior PR Manager
020 7601 1726 | [email protected]k
Steven Kennedy, Senior PR Manager
020 7601 1737 | 07713 073024 | [email protected]