Features

Why I’ve changed my mind about the pension savings lifetime allowance

I used to think the lifetime pension savings allowance was a terrible idea, says Merryn Somerset Webb. I’ve changed my mind on that. But there are some things about the pensions system that I will never agree with.

190510-pensions-lifetime-allowance-

476979963

I've changed my mind about something quite important the pension savings lifetime allowance. Currently this is set at £1.055m. If the value of your pension assets rise above that, you pay tax at what everyone refers to as a "punitive rate" of 55% on the excess when you draw down the money during your retirement or when you hit a so-called "benefit crystallisation event" (age 75 or death).

I've long thought this was a very bad thing. First, £1.055m isn't that much in the context of the kind of return you can make in today's low interest rate environment. Stick it in "safe" gilts and you'll make not much more than £12,000 a year on it. Draw down 4% a year from your capital and you'll only have £36,000 or so after tax. Nice, but not a fortune.

More than that, however, I have felt that the absoluteness of the cut-off penalises good investment performance: the better you do, the more tax you are likely to pay.

So why have I changed my mind?

The lifetime allowance isn't actually all that "punitive"

While we all use the word "punitive" for the lifetime allowance, for most people it is, at worst, tax-neutral. If you withdraw your excess as a lump sum you will pay a 55% charge on it. But if you are a higher- or additional-rate taxpayer you will have received 40% or 45% tax relief on the cash in the first place; you may also have had an employer contribution; and any gains will have been rolling up in your pension wrapper until your draw down. I'd be amazed if you were worse than evens on the deal.

And you don't, of course, have to take it as a lump sum. You can take it as income, in which case you pay a 25% lifetime allowance charge plus your marginal rate of income tax. For a higher-rate taxpayer this gives an effective rate of 55%. But if you are a lower-rate taxpayer when you withdraw the cash, the effective rate is only 40%.

Forty percent relief on the way in and 40% tax on the way out, with tax-free growth in the interim. Is that so bad? Add to that the dirty little secret of the pension regime that pension funds are an extraordinarily tax-efficient way of passing cash on to the next generation and the net effect of this isn't punitive. It's mostly neutral to positive.

I know a lot of people find the system confusing, and the way pension assets are valued for lifetime allowance purposes overly favours defined-benefit pensions, but it is a perfectly good solution to the problem of how we limit the fiscal impact of subsidising retirement incomes. I think everyone will agree that we must restrict it to the amount required for a reasonable retirement as opposed to the amount required for a brilliant retirement (the rest, if you have it, can be saved relief-free).

So, there you go: I really don't mind the lifetime allowance any more. I'm over it. And I suspect I'm not alone. HM Revenue & Customs has just published a study by IFF Research into the well-off, as defined by having an income of more than £200,000 or assets of more than £2m. The results don't surprise me (given what I know of our readers) but I bet they rather surprised HMRC, which appears to work on the assumption that we are all tax cheats until proven otherwise.

It turns out that we mostly want to pay the legally correct amount of tax (although we aren't mad for rates over 40%); that we dislike complexity, grey areas and avoidance schemes, since we don't like uncertainty, and that we are keen to be socially responsible and pay into society via the tax system.

Some of the respondents will have lied, but it rings pretty true to me. So most of us know pension tax relief has to be limited and most of us, once we have done the numbers, can see this is a perfectly reasonable way to do it.

What I still don't like about the pension system: the annual allowance

Right. On to the bit of the pension system that I absolutely cannot and will not come around to. It is the annual allowance and the taper system embedded within it (your annual allowance falls from £40,000 to £10,000 as your income rises from £150,000 to £210,000).

This is all the things people don't like. It's complex, full of what seem to be grey areas and genuinely punitive. It's tough on people working in the public sector who hit the limit they end up having to choose between leaving their scheme, paying a tax bill upfront using current income when they can't access the pension itself for years, or borrowing from their scheme and rolling up the interest (inflation plus 2.4 percentage points in the NHS), plus a tax bill to pay on retirement. This, by the way, is one of the reasons doctors are giving for early retirement.

Almost worse than that, they end up caught in a nightmare of complexity with no real idea of what they might owe until it's too late. However, this isn't just about the public sector. It isn't even all bad that the public sector turns out to be so affected by this. I'd say this sudden explosion of information about just how much more generous a public defined-benefit pension is than a private defined-contribution one is all to the better.

So, to the private sector. Policymakers have little sympathy for those in the private sector earning over £150,000. They reckon anyone earning that year in year out can take care of themselves.

But one of the many things they persistently fail to understand is that earnings in the private sector fluctuate hugely over time. If you are an MP, you make the same every year regardless of age, experience or the state of the economy. The rest of us do not.

Most people who earn over £150,000 will do so for only a couple of years in an entire career. They once saw those years as a magnificent opportunity to build up a retirement pot. No more. Our earnings can also be unpredictable in any given year the self-employed and those who get part of their compensation as bonus might not know how much they earned in a year until the year is over.

But there's another point to make here: if the pension regulations are about reducing levels of overall relief in a straightforward way, rather than about harvesting extra revenues via complication, the annual allowance is entirely unnecessary. The lifetime allowance already does the job of neutralising excess contributions (and if revenue is the issue it is perhaps time to revisit the weirdness of the tax-free inheritance of pensions).

There is plenty of talk, including a policy paper from Royal London, about making special allowances for doctors and the like, or about dropping the taper and just cutting the annual allowance for all so we all know where we are. But why bother? Why not just abolish the hugely stressful and largely pointless annual allowance for everyone?

This article was first published in the Financial Times

Recommended

Look beyond the default options if you want to start taking income from your pension
Pensions

Look beyond the default options if you want to start taking income from your pension

Regulators have come up with four ready-made plans for people who want to start taking an income from their pension fund – but you should still seek h…
26 Jan 2021
Tax returns: make sure you declare child benefit
Personal finance

Tax returns: make sure you declare child benefit

If you owe HMRC a repayment of child benefit cash, you need to act quickly, says Ruth Jackson-Kirby.
26 Jan 2021
Inflation is the easiest way out of this – just don’t expect politicians to admit it
Inflation

Inflation is the easiest way out of this – just don’t expect politicians to admit it

The UK government borrowed £34.1bn in December, a record amount for that month. Britain's debt pile now amounts to 100% of GDP. How are we going to pa…
22 Jan 2021
How to deal with self-assessment tax returns after a very trying year
Tax

How to deal with self-assessment tax returns after a very trying year

The Covid-19 pandemic will complicate the self-assessment tax return process for 2019-20. What if you can’t pay? Ruth Jackson-Kirby has some advice.
20 Jan 2021

Most Popular

Bitcoin does consume a lot of energy – but here’s why it’s worth it
Bitcoin

Bitcoin does consume a lot of energy – but here’s why it’s worth it

Some people question bitcoin’s legitimacy because it uses huge amounts of electricity to maintain its network. But that’s not a failing, says Dominic …
27 Jan 2021
Joe Biden’s spending spree will lift American spirits and markets – but it comes with a sting in the tail
US stockmarkets

Joe Biden’s spending spree will lift American spirits and markets – but it comes with a sting in the tail

New US president Joe Biden is planning to throw trillions of dollars in stimulus at his country’s economy. Markets will love that. But it comes with a…
25 Jan 2021
Think Tesla is a bubble? This might be the best way to bet on it bursting
Oil

Think Tesla is a bubble? This might be the best way to bet on it bursting

The huge rise in Tesla’s share price means that, by market value, it’s now the sixth-largest company in the US and and the world’s biggest car-maker. …
25 Jan 2021