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Deal breaker: Pressure builds over pensions tax relief after Budget bombshell

Radical reforms to the pensions system have sparked renewed pressure to overhaul tax relief during the next parliament as a powerful coalition for reform builds.

Experts are warning a toxic cocktail of dire public finances, a changing pensions landscape and political desire for a fairer system makes change inevitable.

Insurers, politicians and thinktanks have already been paving the way for reform in the name of greater fairness and helping to repair battered public finances.

And while momentum had been building before the March Budget, Chancellor George Osborne’s shock decision to scrap drawdown restrictions effectively shattered the 100-year-old bargain between annuities and tax relief. 

Bank account

From next April, anyone aged 55 or over will be able to take their entire pension pot as cash, although withdrawals will be subject to income tax. But the decision to hand savers freedom over how they spend their pension pot raises questions about the rationale for maintaining the status quo on tax relief.

John McTernan, former political secretary to ex-Labour prime minister Tony Blair, says: “The reforms have opened the door to the Treasury clawing back substantial amounts of tax relief from pensions.

“This was always the obvious implication of the changes. Once you in effect turn a pension into a bank account, the privileged tax position of it becomes hard to justify. The Treasury is utterly unlikely to equalise tax treatment upwards so one would expect a sustained assault on tax relief of pensions.

“Pensions policy was a deal between workers, employees and the government and this Government has rewritten that settlement. The tax treatment will be the first victim and the settlement that underpins the provision of occupational pensions will unravel rapidly.”

Centre for Policy Studies research fellow Michael Johnson has long argued the UK’s pension tax system needs radical reform.

“Annuities were the mechanism for the Government to recoup its investment through tax relief,” he says. “That’s gone and the pensions tax relief system is no longer justifiable – the bargain has been broken.”

Industry experts agree the rationale for maintaining the current pensions tax system has been undermined by the Budget.

Hargreaves Lansdown head of pensions research Tom McPhail says: “Undoubtedly, such a substantial change in a short space of time poses questions about the overall tax treatment of pensions. It brings into question the whole structure of pensions.”

Standard Life head of pensions strategy Jamie Jenkins adds: “The current system of tax relief needs to be reviewed after these freedoms. There is a consensus over the need for reform but not on the solution. We need to build a consensus on a long-term solution, not a knee-jerk reaction, and that requires all-party agreement.”

Towers Watson senior consultant David Robbins says precarious public finances mean tax relief reform will inevitably be on the agenda for the next government.

“The Budget changes raise questions about whether the bargain has changed,” he says. “Questions are being asked about tax relief.

“I think there is still a case for pensions as a distinct product with a more tax-privileged position. The bigger pressure on tax relief comes from the public finances. Someone will be in power next May with the need to fill a black hole.”

Changing position

When it abolished compulsory annuitisation for over-75s in 2010, the Treasury set out five key principles for the tax treatment of pensions.

They were:

  • The purpose of tax-relieved pension saving is to provide an income in retirement
  • Any changes to tax relief should not cost the public purse nor create opportunities for tax avoidance
  • Individuals should have flexibility about when to turn their pots into secure income as long as they do not fall back on the state
  • Pension funds should be taxed at an appropriate rate at death
  • Pension withdrawals should be taxed at income tax levels.

McPhail says: “Those principles look like they have been stretched to breaking point. Clearly the Government’s position is changing. This year’s decisions were not anticipated and everything is in a state of flux.”

MPs have also questioned whether the new freedoms have opened up a £20bn tax loophole, with anyone aged 55 or over able to use salary sacrifice to avoid income tax.

Institute of Economic Affairs director Phillip Booth has called for the 25 per cent tax-free lump sum to be restricted to £50,000 to limit tax avoidance.

He says: “The anomaly in the system is the tax-free lump system and it is now even more stark because it can be serially abused by people putting money into a fund and taking it straight out.”

Political pressure

Last year, the Pensions Policy Institute said the existing system is skewed towards higher-rate taxpayers and it set out options for reform.

The PPI estimated the 2010/11 cost of employer, employee and individual tax relief was £35bn a year. Savers withdrawing from a private pension pay £11.3bn in income tax, meaning there is a net Treasury cost of £23.7bn a year.

The Treasury and Association of British Insurers both welcomed a public debate on the future of tax relief.

An ABI spokesman says: “Insurers are working flat-out to prepare for when pension flexibility comes into force in April 2015, and that is where all efforts should be. We have said repeatedly that there is a case for tax relief reform if it can result in fairer outcomes, achieve lasting political consensus and is linked to higher contribution rates.

”We will continue to discuss this with the political parties in the run-up to the election as it is vital that policy makers understand the complexities involved in reform and that any changes are implemented in a measured and sensible way given the very significant volume of change the industry is currently dealing with.”

Pensions minister Steve Webb wants a flat rate of relief below 30 per cent and insists wholesale reform is needed in the next parliament.

Labour would cut the top-rate relief from 45p to 20p while some Conservative MPs have called for a debate on the higher-rate relief.

Money Marketing understands Ukip is also reviewing the cost of higher-rate tax relief as part of its policy review. Senior party figures believe higher-rate relief should be scrapped but no final decision will be made before the Ukip party conference in February.

At the Tory party conference in September, Treasury financial secretary David Gauke argued the Government had done enough to curb higher-rate taxpayers benefiting disproportionately from pensions tax relief.

Since 2010, the Government has cut the lifetime tax relief allowance from £1.8m to £1.25m while the annual allowance has fallen from £255,000 to just £40,000.

But calls for fundamental reform are growing louder from a powerful coalition of think-tanks and political pressure groups from left and right.

The Trades Union Congress has called for a flat rate of pensions tax relief of 30 per cent while the Fabian Society has suggested a lower rate of 20 per cent.

The Thatcherite Centre for Policy Studies wants to sweep away all relief to create a system where every £1 saved in an Isa or pension is matched by the Treasury.

The neutral Institute of Fiscal Studies has called for wholesale reform of tax relief, saying the case for change is “overwhelming” and the existing system does not act as an incentive.

But while the case for pensions tax relief reform appears stronger than ever, vote-hungry politicians are unlikely to grasp this potentially lethal nettle until after the general election.

Expert View


The pensions tax relief system is utterly ineffective for its purpose of creating a savings culture. The bargain has been broken because the flexibility in accessing pensions is being increased so much.

The new freedoms reinforce the point that pensions are from a bygone age and the tax system is irrelevant to many.

For example, half of the adult population don’t even know what tax relief is. It clearly doesn’t work.

The primary concern for the Treasury is how it can save money and increase the effectiveness of tax relief.

The cost of incentivising saving into a pension product is simply not working as most of the money is handed to those with the highest incomes.

Pensions tax relief is wrestling with a fundamental conundrum that income tax is progressive and as a society we buy into the idea that if you are highly paid, you pay a higher rate of tax.

But it means relief on income tax is regressive and it unwinds that societal contract.

For example, if you take typical 40p taxpayers saving in a pension product, six out of seven of them will drop down to be a 20p taxpayer when they retire. 

They will also get their 25 per cent tax-free lump sum, which means, in effect, they are only paying income tax of 15p and not the 40p they received in relief.

I have no doubt that the pensions tax relief system will collapse under the weight of the public finances.

Michael Johnson is research fellow at the Centre for Policy Studies

Adviser views

Adrian Murphy

Partner, Murphy Associates

I can foresee a further squeeze on the annual or lifetime allowance but I don’t see the new pension freedoms causing it. It is simply the general direction of political travel.

Alistair Cunningham

Director, Wingate Financial Planning

From an ethical point of view it is an unfair tax relief system, but it is perfect as a financial planning opportunity. My gut feeling is that it would be fairer if there was a flat-rate relief of 30 per cent. It would incentivise those on the lower rate and slightly hobble those on the higher rate but they would still be in a better position than not saving at all.


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There are 17 comments at the moment, we would love to hear your opinion too.

  1. I’m sorry but what a load of tosh.

    1. Despite the proposed freedoms you still get taxed on the income, net of PCLS, as has always been the case so unless they propose not taxing income from a pension how can they remove tax relief on the way in?
    2. The new proposals have not introduced a loophole as salary sacrifice has always been an option.

  2. @Sean – if you normally pay tax @40%, then instead dump your income into a pension and immediately withdraw it, then because 25% is tax free you have reduced your tax rate to 30% – definitely not ‘a load of tosh’.

    The lack of savings culture now prevalent is a direct result of removing incentives from the ‘sell side’ at the lower end of the market – savings are dull, and they are long term – consumer goods and holidays are exciting and immediate. To balance that inequality more than tax relief is required, but tax relief is essential. Until our regulatory framework admits that dull but important things need to be sold, not simply made easier to buy the savings culture (and insurance culture) will remain parlous.

    Bring back the men with bicycle clips.

  3. Surely pension contributions are just a deferral of income to be taken at a later date when income tax is paid ?

    However, it is difficult to argue against a standard 30% relief rate being fairer if the sums add up for the Treasury….

  4. There is a lot of nonsense written about pension tax relief.

    This article is a good summary of it.

    I accept the real politic of the situation means that it will probably go sooner or later

    That should not obscure the facts

    Pension tax relief is little more than saying we are only going to tax you on income you receive when you receive it not before you receive it.
    Would all those ignoring this fact be so sanguine if we were taxed on unrealised capital gains?

    Paying tax on my earnings and then locking them away for retirement to at least 57 and possibly later (I have suffered from two retrospective changes to the minimum age I can access my pension savings) isn’t an attractive idea when you consider the opportunity for them to tax the proceeds at the other end as well. By then the Statists will have probably removed virtually all the pension freedoms too.

    Already we are hearing the jealous clamour about the ISA millionaires. The self righteous envy of people who have spent their (or more commonly someone else’s) money rather than saved it knows no bounds. Regrettably far too many of these people are in power in government.

    There has been no real upwriting of the minimum earnings level to pay 42% income tax. It is probably true that this country’s finances have been mismanaged for so long that there’s little alternative but to tax ordinary people a large sum of money but we should not hide this fact by stealth taxes in the pension savings system.

  5. If there are no tax advantages to investing in a pension then investors will not invest in a pension. Abuse of the system can be curbed but if the tax free element is abolished then why would anyone want to limit access to their savings?

  6. Claire Trott - Talbot & Muir 14th November 2014 at 10:12 am

    There are a number of things I take issue with when hearing politicians talking about curbing higher rate tax relief on pensions.

    The first is in order to get higher rate relief you need to pay higher rate tax in the first place so you are already paying a significant amount of tax to the treasury. There will be those that try and take advantage of the system but still, with an annual allowance of £40,000 you are somewhat restricted.

    The second part is how on earth are they going to work all this out for final salary schemes, salary sacrifice, normal employer contributions. This could be a whole host of added complexity that the annual allowance was supposed to deal with. If they are planning on adding another test to contributions maybe they should drop the AA or the LTA.

  7. @Sean
    Totally agree, whenever the subject of tax relief and pensions crops up the same old “experts” are wheeled out, most of whom have employer backed pension schemes and earn enough not to worry about tax relief on their pensions.

    I do agree a flat rate for everyone makes sense whatever the rate, at least 20% hopefully, but if you remove it then tax the income in retirement you may as well destroy the pension industry totally as what would be the point when NISA’s would then make so much more sense for most people.

    As for the Expert View, “half of the adult population don’t even know what tax relief is” well that means half the population does and I think that’s a pretty good result. Google “How many people know where milk comes from” and see what you get, Half know what tax relief is then gets put in perspective.

    Personally I am extremely grateful to George Osborne, in the last few months the number of pension enquiries has risen substantially, the majority of which are from people close to retirement and want to know what options they now have, for the benefit of the doom and gloom merchants not one intends to take the money and run, having saved for their pension they recognise they need to protect it in retirement.

  8. Before doing something stupid with tax relief on the basis that it only encourages the rich to save you have to look at the regime to see why most middle earning people don’t save into pensions. Previous to the budget reforms my advice to any basic rate employee was not to put their money into a pension (they have always been attractive to business owners). The mixture of taxed benefits (except for 25%) and the restrictions on access meant that pensions were a poor deal for those on basic rate. Add in the prospect of means testing in retirement and most people were better off saving elsewhere, especially ISA’s.

    The new freedoms change all of that and make pensions attractive again. It will take a number of years before this message filters through, particularly now that financial advice is so expensive for middle earners.

    In my opinion the rich do not need an incentive to save into low risk products and therefore there is a strong argument for basic rate only tax relief. Keep the higher relief’s on EIS/VCT so that their money can do good in growing the economy.

  9. “Bombshell”…….”An unexpected and surprising event, especially an unpleasant one”. Puts the article into context.
    The “bombshell” is not the reforms. If there is to be a “bombshell”, it will be the failure to make prudent use of the freedom brought about by the changes. The relationship between net tax revenue and the cost to Treasury of incentivising pension saving has not changed significantly. Even the impact of the new rules on taxation of death benefits is overplayed.
    Calm down.

  10. John I was referring to the targeting of tax relief and the article headline not the effectiveness of it.

  11. @Sean,

    Aha, sorry misread your meaning. In that case i roundly commend your comment to the top of the pile.

  12. Claire
    Spot on! This is missed by most commentators.
    If you are in a poor scheme or no scheme and/ or have to make personal provision, no probs to restrict your tax relief.
    However if you enjoy a significant Employer contribution or, say, non contributory DB, then you are by default enjoying 40% relief and NI saving as well!!
    The only way to restrict high rate relief is to correctly value an employer contribution and tax it as a BIK at high rate. If this doesn’t happen, then (especially) those in DB get away with absolute murder whilst those in poor DC are stuffed (again!)
    This point needs shouting from the roof tops – I have written to MP etc on it and continue to do so – never get a meaningful reply of course……

  13. Is there really a problem with fully taxing income and any employer contribution and adding a fixed 33% treasury top up – effectively giving 25% tax relief to all ?

  14. Bones.
    To do that you would have to pay everyone the total cost of their pension as salary and the employee effectively fund the total cost. If you don’t do this the any employer contribution ensures EE obtains 40% relief via the back door.
    All kinds of implications here – NI costs that currently don’t exist on ER conts; correctly value true cost of ER DB contributions etc……
    I believe these ‘problems’ are the reason why they have not changed the current tax relief system to date….and if they want to maintain fairness to those in good ER funded schemes and those who are not, then they cant change the current system. However if they don’t care about fairness then who knows! After all, those who make the rules fall into the taxpayer DB funded camp…!

  15. @suitabilityplease perhaps it is time for employer pension contributions to be recognized for what they are – salary in another form – and as such having tax and NI applied accordingly. As to change would this not only apply to future contributions ? I do care about fairness and see it as unfair that some get untaxed benefits from their employers when others do not. Income is income and should be dealt with equally. what is not fair about that ?

  16. Bones.
    I Don’t disagree – just very concerned that if a change is made it is fair and recognises the true cost/ benefit of decent employer funded schemes.
    I cant see the situation however where a non contributory DB scheme which may cost, say 25% of someone’s pay to fund will result in a 25% pay rise, loss of 12% (0r 2%) EE NI, employer having to pay NI and the individual facing a pension bill on which they will only recover perhaps basic rate relief – political suicide to implement with the public sector…….
    ……so back to my first point that if they do try to restrict high rate relief, it is up to us all to ensure that such a technicality is understood by all so that they dont allow those with decent employer schemes to get away with absolute murder!!

  17. Suitabilityplease Note sure it would necessarily be political suicide. Many teachers who paid 6% now pay 9% and this has incorrectly been described as a 3% increase – with many daft enough to believe it.

    As to basic rate relief – it has to be more. A top up of 33% sound better than 25% tax relief

    I do agree though it will be difficult to get there from here but I believe that the 2 objectives should be that eventually everyone gets the same topup/tax relief and that all income is taxed.

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