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Powerful incentives

The Pensions Policy Institute website at www.pensions is a mine of useful information and not just for people interested in high-level pension policy issues.

I reckon one of the documents on the website is an excellent sales brochure. It is a report by the PPI for Age Concern England entitled Tax Relief and Incentives for Pension Saving.

This is a very worthy document which analyses the current system of taxation of private pensions in the UK and concludes that “all taxpayers pay for the tax incentive system but it benefits higher earners most”.

The PPI concentrates on analysis and studiously avoids making recommendations. However, what I read into this is that if you want to optimise benefit from the UK pension tax system, you should earn as much as possible and, together with your employer, pay lots into a pension.

The crowning glory as a sales document is the implied threat that you should not assume this largesse will be around indefinitely. We all know the power of a buy-now-while-stocks-last campaign.

The report goes into a lot of detail about why pensions are such a good tax deal for high earners. While it is true that investment returns in pensions are now partially taxed, the report notes that “the roll-up of funds invested directly in bonds, property or cash is completely tax-free”. Although “dividend income from equities is taxed at the corporation tax rate – currently 30 per cent – this is above the marginal income tax rate for basic-rate taxpayers but below the marginal rate for higher-rate taxpayers”.

The report goes on to identify a number of further tax advantages of private pensions. The tax-free lump sum needs no elaboration but the report identifies that “receiving tax relief at the higher rate (currently 40 per cent) and paying tax on a private pension in retirement at the basic rate (22 per cent) can increase the value of a pension contribution by up to 40 per cent compared to a tax-neutral regime”.

The report then highlights two key tax advantages of the employer making contributions to the employee’s pension. Because the employer’s contribution also attracts tax relief, “it has a higher monetary value to the employee than simply paying the money directly in pay”.

My personal favourite – and the one that many people forget – is “making pension contributions on behalf of employees also has direct tax advantages for the employer, as employers’ pension contributions are not eligible for National Insurance contributions”. Given that the employer NI rate is 12.8 per cent, when taken with corporation tax relief this is a powerful combination.

I am taking a rather tongue-in-cheek approach to this report and some may say this is inappropriate, given the threat to the current system of pension tax which I infer. But, frankly, I find it hard to envisage a situation where the Government could significantly worsen the pension tax regime for high earners unless it was also going to make other radical changes which would increase private pension provision, such as increased compulsion or a very attractive alternative range of incentives.

My reasoning is that no government would dare to remove in isolation the incentive for bosses to make pension provision because by so doing it would remove the incentive for bosses to be interested in workplace pensions for all employees.

The report does not go into the changes to the pension tax regime which will happen on April 6, 2006 although these changes will be highly significant for the way high earners look at their pension provision.

The ability to avoid annuity purchase or invest in residential property, for example, adds other dimensions to the attraction of pensions for many such people. Also, the report does not separately address any particular issues relating to pensions for the self-employed.

I look forward to the high-level policy debates which are going to happen in 2005 but we should not forget the very strong tax incentives for pensions business today which this report makes clear.


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