Osborne is milking our pension pots dry

This generation of pensioners is better off than any before it. That’s partly because state pension provision has improved a bit. But much more importantly, receipt of private pension income has grown dramatically. The bulk of the incomes of the newly-retired comes from private sources, not from the state. That has been the purpose of pension policy for decades. Anyone with even modest earnings has been encouraged to save for their retirement because the state pension is not intended to provide a decent replacement for earnings. Those with higher earnings must make significant private provision to maintain anything like their standard of living into retirement.

The result is that taxpayers don’t pay huge amounts to fund very high benefits to retired lawyers and bankers, as they do in France and Germany. Our lawyers and bankers largely look after themselves, while taxpayers ensure a basic minimum for all.

Governments of all stripes have recognised that widespread access to good private pensions is an essential part of the implicit deal with the voter — we won’t pay you much of a state pension, but we will make sure you have the chance to save for yourself.

And at the heart of that deal has been the tax treatment of private pensions. It should go without saying that nobody would tie up hundreds of thousands of pounds in a pension, which they can’t access for decades, if there weren’t some benefit for doing so compared to saving in some other way. That benefit is tax relief. I don’t pay tax on my pension contributions but I will pay tax on the pension when I receive it. In truth, it’s not much of a relief — it’s merely tax deferred rather than tax saved. That’s the least I might hope for if the state effectively requires me to save to provide for myself. The real additional relief comes in the shape of a tax free lump sum equal to a quarter of the accumulated pension pot and in the fact that no national insurance contributions are payable on pension contributions made by an employer.

This broad structure of taxation survived for many decades. It was rationalised by the last Labour government to create a system that we were promised would be “simple, durable and readily understood”. If only. The tax regime has been changed and changed again as pension savings have proved something of a milch cow for the current chancellor. By reducing the amount that can be put in a pension free of tax in any one year and the maximum size of the accumulated pot, he has increased tax revenues by more than £5 billion a year.

The latest instalment of these changes means that alongside an annual maximum contribution of £40,000 a year, the lifetime maximum pension pot is to be reduced to £1 million this April. In addition, in a bizarre and complex reform, those on the highest incomes will be allowed to save only £10,000 a year tax-free in a pension. As the maximum contribution is reduced once income exceeds £150,000 the effect for many will be much the same as imposing an income tax rate of more than 60 per cent; a curious outcome from a chancellor so keen to cut the top income tax rate below 50 per cent.

In terms of a lifetime limit, £1 million might sound like a lot. It is quite a lot. But after taking a lump sum it’s only enough to buy an inflation proof pension of about £30,000 a year. This is not a limit affecting only the super rich. As a result of a bias in the system the effective limit is quite a bit higher for those (mostly in the public sector) lucky enough to have an occupational pension tied to salary. But because many of those schemes are rather generous, a surprisingly large number of members may be caught.

Note, by the way, that these changes only affect the current working generation. The effects will not be felt at all by those already enjoying the benefits of a pension accumulated under more generous tax rules and, in the case of salary-related occupational pensions, also paid for in large part by the current generation of workers.

Yet bigger changes would seem to be afoot. The Treasury has been consulting on a more radical revamp of the pension tax system. If reports are to be believed it looks as if the current system of relief whereby income taxpayers get relief at their marginal rate, may be swept away in favour of a single flat rate of relief.

You will hear that this is a good idea because the majority of tax relief, “unfairly”, goes to higher and additional rate taxpayers. But of course it does. They pay the vast majority of income tax. If the 40p rate were increased to 41p they would pay more tax. The fact that they would also get a higher fraction of tax relief wouldn’t alter that fact.

The dangers of fiddling further with tax relief like this are threefold. First, continued change makes planning more difficult. People will make mistakes or just give up on pensions. Second, there are likely to be unintended consequences. If it’s made more expensive to put money in a pension, yet more money in housing is a likely outcome. Third, with the government’s own figures suggesting that the majority of those under-saving for retirement are actually relatively high earners, the implicit contract at the heart of our pension system may buckle under the pressure. The cost of that would be high indeed.

This was first published by The Times as an opinion piece and is reproduced here in full with permission.