Changes to taxing pensions need to be sensitive, but they should happen

Private pensions are the biggest component of household wealth in the UK, bigger even than housing. Getting their design right matters enormously. So does taxing them appropriately.

Sadly, the tax system as it applies to pensions is an unholy mess — and a costly, unfair, complex and distortionary mess at that. It is costly because it is even more generous than a pretty generous benchmark system that would simply relieve pension contributions from tax and then fully tax income on the way out. It is unfair because those with big employer contributions, more common in defined-benefit schemes, get much more generous treatment than the rest of us. The complexities and distortions are exemplified every time we hear stories of surgeons and others saying they won’t take additional shifts, or even retiring, because they face big tax bills for working more.

The worst of these complexities and distortions are recent additions to the mess. The maximum amounts that can be contributed to a pension in any one year free of tax, and the maximum lifetime value of a pension, were cut through the 2010s. For the highest earners, the annual allowance is now tapered down in an incredibly complex manner. It’s the interaction of these rules with generous and inflexible defined-benefit schemes, such as that available to doctors in the NHS, that has so reduced incentives to continue in full-time work.

These limits and tapers were brought in for a reason. They raise a very handy £8 billion in additional tax revenue each year from a relatively well-off part of the population. You can see the attraction.

The limits are also there because some other aspects of the system are absurdly generous. You can take up to a quarter of your pension entirely free of income tax. That’s after having saved out of pre-tax income. That means those with the biggest pensions can take more than a quarter of a million quid completely tax-free — especially handy if you’re rich enough to be a higher-rate taxpayer in retirement.

An even bigger benefit comes from the fact that employer contributions to pensions are never subject to national insurance contributions. HM Revenue & Customs reckons that is a relief worth £23 billion a year, more than half to members of defined-benefit schemes. Employees, and the self-employed, have to pay national insurance on any contributions they make.

Perhaps the greatest absurdity is the fact that pension pots are more tax-efficient as a vehicle for the avoidance of inheritance tax than for the provision of income in retirement. Die before age 75 and you can pass the whole lot on free of both income tax and inheritance tax. It comes inheritance tax-free whatever age you die.

Ripe for reform, then? Surely sort out the inheritance tax loophole. At least limit the income tax-free bit and make it worth the same for everyone, irrespective of what their tax rate in retirement is. Maybe even levy a modest additional tax on bigger pensions in payment in recognition of the fact that no national insurance has ever been paid in respect of employer contributions. Do some of that and you could loosen up on the damaging limits on contributions.

Yet making any of these suggestions, as my colleagues did last week, is met with a wall of opprobrium. Retrospection is the cry. Any fiddling with the tax-free element, or even the inheritance tax treatment, could undo the carefully laid plans of those approaching retirement. If you were relying on the tax treatment to stay the same, then any change, in an upward direction at least, is unconscionable.

I am sympathetic. We all need to be able to plan for our retirement, even our death, with a degree of certainty. But should this be the knockdown argument it is often taken to be? We need to tread carefully, gradually and sensitively, but this cannot be a permanent block to action.

First, it means that change to manifest absurdities will take many decades and huge complication as all existing rights are protected. Which means change will never happen. Which means we bake in injustice for ever. Always remember that one person’s lower tax bill is another person’s higher tax bill.

Second, there is no neat distinction between a tax change that is retrospective and one that is not. The limits on tax relief introduced over the 2010s felt distinctly retrospective to people who had planned their future pension saving on the assumption they’d be able to contribute a lot in the years running up to retirement. Indeed, an increase in pretty much any tax is retrospective to some degree. Cutting the personal allowance, for example, happening on a grand scale over the next few years, will reduce the income that everyone, including pensioners, expected to receive.

Third, the logic of such complaints is that it can only ever be young people who end up getting hit. Which is broadly what has happened. Pension tax relief for present contributors has been limited, with no impact on those drawing their pensions. Rates of national insurance have tended to rise as rates of income tax have fallen, to the benefit of the retired who don’t pay NI.

Nobody has complained about the retrospective gains that cuts in the basic rate of income tax have visited upon those who saved with upfront tax relief at 25 per cent, or even 30 per cent. They expected to pay those rates in retirement, but now enjoy a rate of only 20 per cent.

To repeat, any changes need to be careful and gradual. People must be able to plan with some certainty. But that must not mean complete stasis and an assumption that it must always be the younger generation that stumps up while better-off members of older generations get away scot-free.

This article was first published in The Times, and is reproduced here with kind permission.