The factors used in pension tax law to measure defined benefit pensions have become increasingly outdated since the 2006 simplification project. Arguably, the factors used at that time to convert DB into cash amounts for measurement against the annual and lifetime allowances were generous to members. Today, there can be no argument that defined contribution savers get a comparatively rough deal.
A £50,000 a year CPI-linked pension for a 60-year-old with a 50 per cent partner’s pension would cost about £2.4m to buy on the open annuity market. That cost is strangely all within the lifetime allowance if the trustees of a DB scheme buy the annuity. If, however, an individual DC saver buys the annuity then the pension produced by £1.4m of their £2.4m fund is subject to an extra tax charge of 25 per cent.
Put another way, the £1m lifetime allowance is only enough to buy a CPI-linked income with a 50 per cent partner’s pension for a 60-year-old of just over £20,000 a year. Compare that to the £50,000 annual income a DB scheme can provide without a lifetime allowance charge.
A £20,000 pension equates to two-thirds of a pension for someone with a final salary of just £30,000. So, in thinking about DC members and the £1m lifetime allowance, we are not talking about the mega-rich anymore.
This situation has mainly arisen out of the increasing cost of promising a fixed lifetime income. The bonds used to back these promises are trading at all time highs. And there is no sign of these pressures abating any time soon.
Excess demand created by government bond buying programmes, investor flight to safety, DB liability matching and extremely low central bank interest rates are all conspiring to drive bond yields ever lower.
Those forces are also driving DB transfer values to record levels but, at the same time, the lifetime allowance encourages members to stay in those schemes, even if the new flexible options available in DC schemes are a better solution. So much for freedom and choice.
Such artificial barriers should not exist. The system should not prevent the free flow of savers from one type of pension to another if they think it better meets their needs. Nor should they prevent the free flow of capital to assets such as equities, which are usually preferred by DC savers.
The lifetime allowance encourages a conservative approach to DC investment choice because there is no point taking excess risk in the knowledge a 25 per cent tax charge applies to the reward in addition to your highest marginal tax rate. For a higher rate taxpayer, the combined tax charge is 55 per cent. Why bother taking risk when 55 per cent of the reward goes to someone else?
This favouritism in the pension tax rules towards DB schemes and their members should stop. Three-quarters of the £34bn in gross pension tax relief is consumed by DB schemes, despite their active members now making up roughly 20 per cent of the working population. Why is it that so much of our tax relief is enjoyed by so few?
There might be an argument for favouring these workers if wealth were being redistributed. But that is not the case. Median weekly earnings in the public sector, where roughly five out of six DB members work, are £589 compared to £501 in the private sector where DC schemes dominate.
Some DB tax relief applies to deficit recovery contributions making up for the underfunding of past accruals, but most of it is incurred in respect of new accruals for active members or paying pensions to members of pay-as-you-go schemes.
The result is that DB scheme members have it all ways. Most of the tax relief on the way in and less of the lifetime allowance charge on the way out. The lifetime allowance is preventing people using their pension in a way that suits them best. It is discouraging risk taking. What is more, it is rewarding a very small part of the workforce that already enjoys most of the tax relief. It is time it was scrapped.
John Lawson is head of financial research at Aviva