Pensions and Lifetime Savings Association has published a report indicating potential tax relief reforms will not increase retirement income for lower earners, but will reduce pension income for millions of others who pay higher rate income tax.
The two most discussed reforms of pensions tax relief, removing the higher rate of relief and introducing a new single rate of relief at 25%, would not significantly improve the retirement income of lower and median earners but would result in reduced pension income for millions of others who pay higher rate income tax, most of whom are already not saving enough for retirement, according to new analysis by the Pensions and Lifetime Savings Association (PLSA).
During the past year, there has been much speculation in the media that the Government may be looking at reforming pensions tax relief as a source of additional revenue to help pay for the costs of the pandemic or to support the cost of changes to social care.
In a report published today, ‘Pension Tax Reform: Implications for Savers’, the PLSA explores how a selection of workers with different levels of income and in different types of workplace pension scheme would be affected by four potential reform options. These include flat rate relief set at 20%, 25% and 30%, and TEE – whereby pension contributions are taxed at a person’s marginal rate of income tax but investment returns and pension income are exempt.
The report shows the effect on private pension income, total retirement income, retirement replacement rates and the PLSA’s Retirement Living Standards.
The analysis, based on modelling by the Pensions Policy Institute (PPI), finds that removal of the higher rate of pensions tax relief would be of no benefit to the majority of taxpayers who pay Basic Rate income tax and even the introduction of a new, more generous, single rate of 25% would only result in a modest uplift in pension income for some savers.
Basic Rate Taxpayer / Median Earner
If higher rate tax relief was removed and everyone received a single rate of relief at 20%, a person on median earnings throughout their working life (i.e., at age 22 earning £19,000 per year and at age 68 earning £29,000 per year) would see no change to their pension contributions or tax bill.
The same person, however, would see an increase in their private pension income due to a rate of tax relief of 25%. This would result in a higher pension of between 5% and 8% depending on the type of scheme they are in. For someone saving at the 8% minimum AE level the additional annual income in retirement would be around £200 per year.
However, despite this higher private pension income, when the person’s overall replacement rate from both their state and private pension income is taken into account, the application of tax relief at 25% would result in only a very small increase in pension income. Under the current system they could expect to receive a replacement rate of 52% and under a single rate of 25% they could expect to receive 53%.
Higher Rate Taxpayer – 90th Percentile Earner
All higher rate taxpayers would pay more tax for every year that they remain a higher rate taxpayer. For some, particularly those in DB schemes, there would be very substantial tax bills to pay and, for their schemes, a decision to make as to whether to allow the tax bills to be paid by the scheme in return for lower benefits at retirement.
Under a reform where all the higher rate of tax relief is removed (a 20% single rate), someone who remains a 90th percentile earner throughout their working life (i.e. at age 22 earning £29,000 per year and at age 68 earning £64,000 per year), would pay between £34,500 and £205,700 in extra tax over a working lifetime, depending on whether saving into a DC scheme at the 8% minimum AE rate or in a typical DB CARE scheme such as that used in the NHS. The resulting reduced pension contributions would lead to the high earner’s retirement income falling by between £900 per year and £7,500 per year, depending on the type of scheme. This amounts to a reduction in private pension income of over 20% in all scheme types.
If a single rate of tax relief at 25% is introduced, the same person would also lose out, though less than is the case if all higher rate tax relief is removed. At this rate, a 90th percentile earner would pay between £26,300 and £150,400 in additional tax, depending on whether the person is saving in a DC scheme at the minimum AE level or in a typical DB CARE scheme. This results in a reduction in private pension income of 16%.
If we consider this person’s overall replacement rate from both the state pension and private pensions, if all Higher Rate tax relief is removed (i.e., a 20% rate is used) and the person is saving at the 8% AE minimum in a DC scheme their replacement rate will fall from 33% under the current system to 31%. If the person is saving in a typical DB CARE scheme, the replacement rate will fall from 115% to 110%. If a single rate of tax relief of 25% is adopted they have very similar outcomes.