Pension tax reforms could boost middle earners’ pension pots by 20 per cent

Substantial losses for high earners likely to be behind Chancellor’s pre-Budget postponement

Radical pension reforms could significantly boost the pension savings of the majority of earners, but at the cost of substantial losses to high earners and major disruption to the industry. These costs are likely to have led to the Chancellor backing off changes last week, according to a new report published today (Thursday) by the independent think-tank the Resolution Foundation.

The report analyses the scale of potential gains and losses from the two main proposals that have been under consideration by the government – moving to a flat rate of pension tax relief and an even more radical plan of pension ISAs. Despite the Chancellor favouring reform, the Treasury last Friday confirmed that changes would not be taking place in next week’s Budget.

The Foundation says that the high cost of the current system (around £35bn a year) and its highly regressive nature (the top 1 per cent of taxpayers receive 13 per cent of all tax relief, the same as the entire bottom 50 per cent of taxpayers) make the economic case for reform very strong, even if the political argument is far more challenging.‎

It says that reforms focused on reducing the generosity for higher earners and increasing it for lower ones could both save the government money and make the system less regressive.

The report shows that moving to a flat rate relief of 30 per cent would boost the pension pot at retirement of a full-time median earner aged 30 by £11,200 (+13%), and by £3,200 (+14%) for a full-time earner on the National Living Wage (NLW). However, a high earner on £60,000 would lose £22,000 – a fall of 14 per cent compared to the current system.

The Foundation notes that the increasing number of lower earning savers being brought into the system as a result of auto-enrolment will reduce the revenue neutral flat rate over time, from 30 per cent to 28 per cent by 2025. It adds that the 33 per cent rate favoured by some would come at a substantial cost to the government.

A more radical move to ISA-style pension reforms – scrapping upfront tax relief and instead exempting pensions in payment from tax – also has the potential to boost the pension pots of low-to-middle income households. However, the report notes that the scale of change – and the disruption caused to the industry – also carries huge risks. This was the Chancellor’s preferred approach, prior to last week’s announcement.

The report considers a number of options, including 50 per cent match and cap, whereby the government adds 50p to every £1 of post-tax income saved, up to a limit of £1,000 a year.

The report shows that a ‘pensions ISA’ of this type would boost the savings of a full-time median earner by £21,400 (+26%). The gain would be £4,400 (+20%) for a full-time earner on the National Living Wage, but someone earning £60,000 would be much worse off, losing £19,700 (-12%).

It says that while there are clear merits in moving to a more progressive system, change would need further consultation with industry to ascertain the risk of wider disruption to our saving culture. The Foundation also notes that smaller reforms, such as reducing the maximum lump sum that can be taken tax free, could make the system less regressive and deliver savings for the Exchequer.

Adam Corlett, Economic Analyst at the Resolution Foundation, said:

“The Chancellor was right to look at changes to pension tax relief, which is very expensive and disproportionately benefits higher earners. The savings challenge our country faces is to boost the retirement incomes of low-income households – not give tax breaks to high earners – and that should be the priority for reform.

“But the scale of the current tax advantages also mean that it is inevitable that many people will face big losses as a result of any reform. This ultimately looks to have delayed the reforms for now.

“The government still has a range of options it could choose from, including flat rates of relief and the more radical option of moving to ISA-style savings. The second of these would need more consideration and consultation, particularly given the risks to an industry still bedding in other recent reforms.

“The current political climate may have postponed the Chancellor’s plans to overhaul pension saving. But with the reforms having the potential to significantly improve the retirement prospects of the majority of workers it’s an issue that he should return to.”

Notes to Editors

• The Resolution Foundation report, authored by Adam Corlett and Matt Whittaker, also includes analysis provided by the Pensions Policy Institute (PPI).