One more example of our unfair two-tier pensions system

In this week’s magazine I write about the new lifetime limit for pensions.

You used to be able to save up £1.5m into a pension before you got hit with any extra taxes. Not any more. Unless you apply for FP14 in the next few months (read the mag and you will know what FP14 is, I promise) any savings over £1.25m will be taxed at the usual punitive rate of 55%.

If you are in a defined contribution scheme (the one where you put money in and rely on investment returns for survival) the payment of the tax is pretty simple: you retire and you pay a lump sum tax on any excess. So if you look in your pot at 60 and find it has £1.5m in it, you hand £137,000 over to the taxman. Job done.

But what about defined benefit schemes (the ones that guarantee you an inflation linked pension payment for life linked to your salary)? How do you pay the tax there? I was wondering about this, so I called pensions consultants Barnett Waddingham and asked them.

The answer is that the value of the pension for regulatory purposes is calculated on retirement at 20 times the annual payout. So if you are getting a pension of £40,000, the value is £800,000 and there is no problem.

If, on the other hand, you are getting £100,000 (lucky you) and your pension is deemed to be “worth” £2m, there is a problem. You can either take the excess as a lump sum payment and pay an instant £55% on it, just as anyone else would, and then take the rest of your pension as a normal payment, or (and the majority of DB funds insist on this) you can take it as part of the pension anyway just with lifetime allowance (LTA) tax deducted on an annual basis.

I am not entirely sure why, but that tax normally works out at 25% of the excess (this seems low relative to the 55%). The maximum you can get before you hit with LTA tax at the moment is £75,000 (20 x £75,000 adds up to the current LTA of £1.5m). So if you are in line for £100,000, you pay 25% on £25,000 before you get the payout . That makes your final annual pension not £100,000, but £93,750 (£100,000-£6,250).

OK. Those of you who have stuck with me through all this will now be rewarded with the interesting bit. This system is horribly, horribly unfair to DC pension savers. Let’s just look at the current allowance to see why.

You can save £1.5m, tops. What can you buy in the way of an inflation-protected income for £1.5m? A standard RPI linked annuity rate comes in at about £2,800 per £100,000 at the moment. So you can buy an income of £42,000 before you get hit with a punitive tax. That’s nice.

But look at how much your DB peer can get in income before he gets hit with the same tax. It’s £75,000. Which is much nicer. But not altogether fair.