Pensions were originally designed to provide an income in retirement. It is perhaps odd, then, that in its attempts to curb the cost to the Exchequer of pension tax relief, the Government has focused on the size of pension funds rather than the level of income people receive in retirement.
Before we look at whether there is a better alternative, it is worth examining how we got to where we are today.
Ten years ago, the introduction of pension simplification gave us two new concepts: the lifetime allowance and the annual allowance. At first glance they did indeed give us simplification, at least based on what they were intended to achieve.
This decade we have seen a number of cuts to the LTA and a steadily falling AA culminating in the incomprehensible tapering for higher earners.
In thinking about the LTA I turned back to the National Audit Office report from March 2004 entitled “The Government estimate of the impact of the pension lifetime allowance”. One particular paragraph stood out:
“It is factually accurate that, assuming a 20:1 valuation factor, £1.4m is broadly equivalent to the maximum pension allowable under the current occupational pensions regime, which includes the earnings cap. That does not mean that such a sum would at any given time necessarily be enough to buy such an income.”
When the LTA finally came into force it was £1.5m instead of £1.4m and the earnings cap was just a bit over £100,000, so the maximum pension referred to was broadly two thirds of the earnings cap; somewhere around £70k per annum.
At this point we started to see the divergence of maximum benefits from defined benefit or defined contribution schemes. For DB schemes, ignoring potential lump sums, the benefit tested against the LTA is 20 times the pension payable from the scheme. So when the LTA got to £1.8m the maximum was broadly £90,000 p.a. Now at £1m it would be £50,000 p.a.
For DC schemes, arguably the best measure for maximum benefits is what could be purchased by a fund valued at the LTA on the annuity market. When the LTA was £1.25m, annuity rates at the time could have purchased an index-linked joint life pension for a 65-year-old male of some £35,000 p.a. Now, following the April fall to £1m, and based on current annuity rates, the maximum annuity that could be purchased (male age 65, index-linked, joint life) is just over £25,000 p.a. with the trend looking downwards. Interestingly, depending on your source, this would be less than national average earnings.
For me, this raises two important issues:
- The differing maxima for DB and DC seem patently unfair.
- The LTA as it stands is not fit for purpose. We continue to focus on the fund value as opposed to the annual income that can be derived from that fund value.
Abolition of the LTA might not be seen as politically appropriate – all that tax relief going to those who can afford to pay the most pension contributions. On the other hand, however, society wants individuals to be as self-sufficient as they can, not least so they can afford to pay tax back into the economy.
Could we set a level of income that is felt to be the right level of retirement income on which tax relief is given? Should this be higher than national average earnings?
With an ageing society and fewer taxpayers to fund the state pension, the Government’s options to control income levels in retirement are falling.
This policy has been put forward in the US with the idea of a maximum based on the size of tax-favoured pension funds such as IRAs and 401k schemes. The proposed limit has been expressed as that needed to provide the maximum annuity permitted for a tax-qualified DB plan under current law. In practise this maximum fund value could fluctuate in line with the underlying interest/annuity assumptions.
I am not saying this is the definitive way forward but with the ongoing debate on pensions tax relief perhaps we should change our focus to “income level” to assist retirees left powerless in dealing with the double whammy of LTA and falling annuity rates.
Mike Morrison is head of platform technical at AJ Bell