John Lawson: The delicate balancing act of pension tax relief reform

To change to a new regime of pension tax relief, we would have to find a method (or methods) of dealing with benefits accrued under the old system. There are two potential ways to do this: to grandfather benefits already accrued, or to transfer existing benefits into the new world.

Grandfathering is the traditional method of dealing with large-scale changes to pension tax. The most recent example is the pensions simplification project, which in 2006 replaced eight sets of tax rules with one new one.

Some of those eight tax regimes, such as the ones for occupational schemes and retirement annuities, allowed more tax-free cash than the new system. Grandfathering protected this.

The old regime for personal pensions had no cap on benefits whereas the new system does, and for those benefits expressed as a promised pension, a method for converting them into a cash value for measurement against the new lifetime allowance had to be found.

The result is we gained a plethora of transitional rules, such as primary protection, enhanced protection, fixed protection (2012, 2014 and 2016), individual protection (2014 and 2016), protected tax-free cash, block transfers, protected pension age and so on.

Such is the extent of transitional protections that  pension simplification has become an ironic phrase that makes pension professionals snigger. That is, when they are not pulling their hair out trying to understand the complex choices these rules confer.

So, if grandfathering is out, what about a one-off exercise to move all existing accruals into a new regime? How would that work? Ideally, what you would want to do is cancel out all the tax relief already received on the assumption that benefits at retirement are received tax-free. But, again, that is easier said than done.

People who have received tax relief at the basic rate of 20 per cent might have that neutralised with a 20 per cent tax charge. But today they also receive a tax-free lump sum of 25 per cent, which means they are only taxed on three-quarters of their fund.

That would suggest the correct balancing tax charge for this group is 15 per cent (that is, 20 per cent tax on three-quarters equals 15 per cent of the whole).

However, the Government’s own figures tell us that nearly half (48 per cent) of over-65s do not pay any tax at all. So, taxing the pension funds of these people at 15 per cent would be 15 per cent more than they are likely to pay under the current system. This hardly seems fair, particularly when you consider that this 48 per cent are the poorest pensioners.

Moving to higher rate taxpayers, the idea of a one-off transition charge raises further issues. A higher rate taxpayer, even if they remain a higher rate taxpayer in retirement, pays an effective rate of 30 per cent (40 per cent tax on three-quarters of retirement savings) but only on the income or capital that falls into their top-slice of income. Their first slice of income is taxed at 0 per cent and the next slice at 20 per cent, suggesting a one-off balancing charge needs to be a blend of 0 per cent, 15 per cent and 30 per cent.

Even if it were possible to come up with a single blended balancing charge, there would still be unfairness. Those just breaching the higher rate threshold would not get as good a deal as those with taxable income of, say, £120,000 who have marginal tax rates as high as 60 per cent but who might escape with a balancing charge of, say, 25 per cent.

And what about those who might have paid a lifetime allowance charge, either because they are already over the lifetime allowance or because their current fund value makes a future breach highly likely? Or those in defined benefit schemes, where a balancing tax charge would manifest itself as a reduction in benefits? Is it legally possible to cut benefits?

Aside from the issue of ensuring the balancing tax charge is fair to most, we would also introduce considerable moral hazard.

Already, freedom and choice has shown us some foolhardy individuals who have stripped out as much as £250,000 from their pension at tax rates of up to 45 per cent to invest in tax-inefficient ways. Thankfully, most people have not acted in this way, perhaps because of the reality check that paying tax on withdrawals delivers.

How a savings system that allows the whole fund to be withdrawn tax-free would work in a country whose culture supports welfare for those without savings is an equally important consideration.

John Lawson is head of financial research at Aviva