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