Mike Morrison: Govt has lost sight of what a pension is for

Mike Morrison 700x450

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

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Comments

There are 10 comments at the moment, we would love to hear your opinion too.

  1. This is far too logical, rational and fair – it will never catch on!

    • Indeed, since when are politicians interested in logical, fair or rational, especially when they themselves do not suffer as they have their ridiculously generous DB schemes paid for in full by us the tax-payer.

      Can you imagine HMRC, themselves beneficiaries of a very generous DB scheme paid for by the tax payer being in favour of this?

  2. The only thing I would say- Why does a pension wrapper have to be for income? Retirement in future will look very different, people will live longer, work more flexibly, have various assets to use towards delivering income and cash needs later in life- why do we need these definitions? The ability to save in tax efficient environments and then the choice in how to spend their savings is all people want- with a decent state pension to cover the basics.

  3. What you have failed to factor into your thinking is that the public sector, and in particular MPs, are on DB schemes. Can you see MPs voting for a tighter restriction on their pensions?

  4. Of course they have. Not only the good points that you have made, but with all this draw down nonsense. Pensions were never meant to be inheritable. Nor were they there to gamble with retirement income.

    Now we are going to have a lifetime ISA it really does point to Westminster really having scant idea of the mess they are creating. What worries me is that when they have finally finished dismantling pensions, will they the start on ISAs? Limiting the total amount? Withdrawing the tax free status on income? Limiting the contributions?

    It is a real fool that would trust a Government.

  5. From the taxpayers perspective, I’ve always though it a bit odd that we provide tax relief incentives to those who already have sufficiently large funds to be (more or less) independent of State assistance in retirement.
    So why not just abolish everything else (LTAs, AAs etc) and instead have a simple lifetime contribution limit linked to your NI number, up to which a flat rate (30%?) of tax relief is granted on contributions. It could be set at a level which, when combined with the state pension, roughly equates to financially “ok”. To be used whenever you want during your life.
    But most impt, with a guarantee of NO MORE GOVT TAMPERING so we all know where we stand long term!!

  6. So Mike when the current pension minister gets a better offer perhaps you might volunteer for the role and give us a coherent pensions strategy….

  7. 30 years of prejudicial government meddling with the pensions framework has done nothing but damage to it and, worse still, there seems to be no end in sight. It’s all cuts, cuts, cuts and the removal of any indexation of allowances. A young person starting out now with regular contributions to a PP is GUARANTEED to breach the LTA decades before s/he reaches retiring age. So what kind of proposition are we selling them? Something that they’ll have to give up on in a few decades in favour of an unknowable alternative, probably an ISA with all the dangers of all too easy access that that entails. What kind of government policy is that?

  8. Mike – thank you and I completely appreciate the anomalies appear unfair. But I’m with Paul. We tend to pity the poor millionaire a little too much IMHO. They’ve had tax relief on £1m at 40, perhaps even 45%. Compared to average Joe’s 20% on less than £50,000.
    (And, would anyone REALLY cash in 100% of a £1m pension pot for an annuity at age 65 – now!?)
    There are many things we should be asking the Government to do to make retirement saving fairer and more attractive – and to all, not just millionaires. A rise in the LTA is not up there on my version of that list.

  9. Mike – I have known you a long time, and you can always be relied on to serve up something well-reasoned and provocative. This is a blinder. Next step is simple, get yourself appointed as pensions minister.

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