A simple solution to pension tax relief

Ask anyone who does anything related to pensions these days about pensions tax relief and they will all tell you the same thing: its days are numbered. Why? Because it costs a fortune (think £35bn a year) and much of that fortune has historically been taken up by people who don’t need incentives to save – they’re likely to be doing  it anyway.

Note that 70% of pension tax relief goes to those in the higher rate tax brackets. That’s why the minister of state for pensions, Steve Webb, wants to bring in a flat rate of pension tax relief of 30% to replace the current system whereby you get relief at your highest marginal rate of income tax.

That’s something that would effectively give lower rate taxpayers a pay rise every time they saved, while limiting the benefits to higher rate taxpayers.

And it is why think tank the Pensions Policy Institute issued a report earlier in the summer entirely agreeing with the idea. However they added in a new twist – a cap on the amount of money that can be taken tax-free on retirement.

At the moment, everyone can take 25% of their pension cash out as a lump sum, entirely tax-free. PPI would like to see that percentage reduced or simply capped at £36,000 for everyone.

I can see the arguments for all this – the current relief system seems needlessly expensive. But the solutions on offer all seem bizarrely complicated when – to me at least – the solution is very simple.

If we must do something (and it appears we must always do something), why not just limit everyone to a certain level of pension tax relief by capping the amount of money that can be paid into a pension over a working lifetime?

We could get rid of the ludicrous life-time allowance system, which penalises people for investing well (see my previous posts on this) and instead cap contributions, and hence the cost of relief.

Think of the point of pension tax relief in the first place. It’s to encourage people to save enough so that they won’t be a burden on the taxpayer in their old age.

The priority of the system should then be to incentivise people to save that much inside a pension, but not to waste public money by incentivising them to do much more. Which brings us to the key question – how much is enough?

I’ve noted this before, but I suspect the answer is enough to generate an income of something in the region of £20,000, so around £4-500,000.

I accept that this isn’t as straightforward as it sounds (you’d have to inflation link the limit and it would have to be firmly applied to public-sector pensions as well as private sector pensions), but it is an awful lot more simple and significantly cheaper than most of the other ideas on offer.