Will pensions be targeted to fill the £20 billion NHS funding gap?

With the respected Institute for Fiscal Studies (IFS) warning the so-called ‘Brexit dividend’ doesn’t actually exist, the Government is facing questions over how it will find the extra £20 billion a year Prime Minister Theresa May has promised for the National Health Service.

The money is expected to come from a combination of increased Government borrowing, freezing existing tax thresholds and higher taxes (assuming economic growth doesn’t vastly outstrip current expectations).

With pensions often seen as an easy revenue raising option for the Chancellor, Tom Selby, senior analyst at AJ Bell, considers five ways pensions could be targeted and the dangers inherent in each.

1. Abolish higher-rate pension tax relief

With the NHS close to breaking point in the face of an ageing population, Chancellor Hammond faces some unpalatable choices to raise the £20 billion of extra cash promised by the Prime Minister.

The most obvious revenue source, as always, is pension tax relief. At the extreme end of the scale the Government could axe higher-rate relief altogether, meaning everyone would receive basic-rate relief at 20%. The attractions of this are obvious, with estimates suggesting it could net the Exchequer between £5 billion and £10 billion a year*.

However, going down this route would be fraught with risk. While automatic enrolment reforms are slowly beginning to nudge the UK towards saving for retirement, slashing incentives for middle Britain would put that progress at risk.

The Government would also likely face a rebellion from Conservative backbenchers if it opted for an approach that risks alienating core voters.”

2. Cut the annual and/or lifetime tax-free allowance

Slashing the amount people can save in a pension tax-free using the existing annual and lifetime allowance mechanisms might be an easier option politically than scrapping higher-rate relief - although it is unlikely to be anywhere near as lucrative.

Reducing the £40,000 annual allowance might be seen as the more pragmatic option, given the vast majority of people won’t get anywhere near this level of saving in the course of a year.

Ten years of pension tax relief cuts

Policymakers could even go a step further by scrapping generous ‘carry forward’ rules which allow savers to utilise unused allowances from the three previous tax years in the current tax year, thus boosting their annual allowance to a maximum of £160,000. However, care would need to be taken not to hit the growing self-employed sector who are most likely to use this flexibility.

Cutting the lifetime allowance – which currently stands at just over £1 million – might also be tempting. However, it’s worth remembering that while £1 million might sound extremely generous, that only buys a healthy 65 year old an inflation-linked annuity with spouse’s pension worth around £22,000 (after tax-free cash has been taken).**

Another alternative would be to reduce the defined benefit lifetime allowance factor which currently allows members to build up an inflation-protected pension with spouse’s benefits worth around £50,000 a year without paying a lifetime allowance charge.

This is effectively about double the lifetime allowance available to a defined contribution member and looks incredibly generous in the current fiscal context.”

3. Cut pensions tax-free cash

The nuclear option for Government would be to attack the 25% tax-free lump sum available at retirement.

While this would potentially raise billions of pounds, it would also represent an attack on one of the few features of pensions that is both popular and generally well understood.

Furthermore, if policymakers wanted to go down this route a mechanism would be needed to recognise that contributions made to-date have been based on 25% of withdrawals being tax-free. This combination of unpopularity and complexity will likely force the Government to look elsewhere for tax savings.”

4. Adjust the annual allowance taper

At the moment the amount people with total earnings £150,000 or more can save each year in a pension tax-free is reduced by a complex annual allowance ‘taper’.

Under the taper, for every £2 of ‘adjusted income’ above £150,000 the annual allowance drops by £1, to a minimum of £10,000.

If the Government wants to boost tax revenues from higher earners, it could shift the point at which the taper kicks in downwards to, say, £100,000. This could prove an attractive option as it specifically targets the very highest earners in society.”

5. Tax pension death benefits

If the Government doesn’t want to attack the pensions of the living, it could instead target pension death benefits.

At the moment if someone dies before age 75 they can pass on their entire fund to beneficiaries tax-free, while if the die after 75 it is taxed at the marginal rate.

These rules look extremely generous and could well come under the microscope ahead of the Budget later this year.

While death taxes of this nature are undoubtedly effective revenue raisers, the Government risks creating negative headlines at a time when the Prime Minister’s authority among her own MPs appears relatively weak.”

*Pensions Policy Institute, ‘Future trends in pension tax relief’, July 2016 http://www.pensionspolicyinstitute.org.uk/publications/reports/future-tr...
**Source: Money Advice Service annuity calculator. Assumes healthy 65 year-old takes 25% tax-free cash (£250,000) and uses the remaining £780,000 annual allowance to buy an inflation-linked annuity with 50% spouse’s pension.

These articles are for information purposes only and are not a personal recommendation or advice.