SCRAP HIGHER RATE PENSION TAX RELIEF
Michael Johnson: £360 billion spent over the last decade on encouraging pension savings is misguided and ineffectual
In the lead-up to the Autumn Statement, leading pensions analyst Michael Johnson calls for a radical overhaul of the financial incentives currently provided by the Treasury in a largely failed attempt to encourage retirement savings.
In Costly and Ineffective: why pensions tax relief should be reformed Michael Johnson shows that these incentives are hugely expensive. They comprise:
- tax relief on contributions (cost: £26.1 billion in 2010-11)
- a tax-exempt 25% lump sum at retirement (£2.5 bn)
- NICs relief on employer contributions (£13 bn) and
- tax relief on investment income (£6.8 bn).
Over the last decade, relief on income tax and NICs has totalled £358.6 billion, (excluding tax foregone on the tax-exempt 25% lump sum).
Over the same decade, the Treasury’s cost of funding tax relief (i.e. the yield on gilts) averaged a real 3.9% per annum, yet the average real annual return on all UK pension funds was a paltry 2.9%, i.e. 1% per annum less. Thus, the return on the Treasury’s co-investment with people saving for retirement, through the medium of tax relief, has been negative £17.5 billion. With most gilts being purchased by pension funds, this is partly explained by industry charges.
These tax incentives are clearly flawed:
- they are crude and mis-directed, primarily towards the wealthy;
- they lack any emotional resonance; and
- they do little to encourage a savings culture amongst younger workers.
Furthermore tax relief is not simply about deferred taxation – just one in seven who pay higher rate tax whilst working ever pay higher rate in retirement. From the Treasury’s perspective, this is a bad deal; higher rate tax relief is a huge cost (£7 billion a year) to the state, not an investment.
Michael Johnson calls for a radical realignment of the savings incentives framework. This paper’s nine proposals include:
- combining the annual contribution limits for ISA and tax-relieved pension saving into a single limit of between £30,000 and £40,000. This would represent only a relatively small reduction in the cost of the financial incentives (of between £1.8 billion and £600 million). The full limit should be available for ISA saving;
- shelving higher rate tax relief, thereby saving £7 billion annually but, as a partial quid pro quo, reinstating the 10p tax rebate on pension assets’ dividends and interest income, at a cost of roughly £4 billion per year; and
- replacing the 25% tax-free lump sum concession with a 5% “top-up” of the pension pot, paid prior to annuitisation. This would be cost neutral.
Tim Knox, Director of the Centre for Policy Studies, comments:
“The Chancellor faces many difficult choices in the forthcoming Autumn Statement. It is easy to say what he should not do: to dream up new punitive taxes which are inspired more by political signalling than by their financial contribution to the Treasury or by their impact on the economy. Rather, sensible reform of the financial incentives for savings could yield a double dividend of increasing long-term retirement savings while also reducing the immediate cost to the Treasury.”