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Cutting tax relief on pensions

October 14, 2010

Sarah Smith


The latest proposed spending cutbacks, announced today, are restrictions on the amount of money that can be paid tax-free into a personal pension each year – from £255,000 to £40,000 – and on the amount that can be built up in employer pensions.

While this will be unpopular with the pensions industry, this proposal has a lot to recommend it. There is a strong reason for the government to provide some incentives for people to save in a personal pension. Without tax advantages it is not an attractive form of saving because of its inflexibility – in the UK the money is locked away until retirement and then most of it has to be converted into an annuity (an annual income). This is exactly what the government wants people to do to prevent them from blowing their savings before or after retirement and falling back on the state – as apparently happens in countries such as Australia where annuitization is not compulsory. But without giving extra tax privileges, it is not clear that anyone would choose to save in this way. Following this argument, however, the “right” level of incentives will ensure that people build up a pot big enough to keep them off means-tested benefits (with a bit on top so they feel that the sacrifice has been worth it). There is no particularly strong economic reason to subsidize pensions above this level and allowing people to pay such huge sums tax free into a pension each year favours the better off.

Whether £40,000 is the right limit is harder to say. Means-tested benefits (pension credit) are currently worth £132.60 a week for a single person. You need a pension pot of more than £200,000 to get an annuity that will pay you this amount (for a woman aged 60 buying a single life annuity linked to inflation) – although this is an upper limit since most people will have some state pension that reduces the amount of means-tested benefit they receive. If people contribute to a pension during most of their working lives, the annual limit of £40,000 seems more than enough to reach this level of savings. There may be some, however, who were planning to concentrate their savings in a few good years who will be hard hit. More flexibility in being able to smooth contributions over years would help them.

However, it is less clear that the proposal will generate the type of savings that are currently being talked about – £4 billion a year in the cost of tax relief. These estimates typically assume that the money would otherwise be saved in a fully taxed form of saving – such as regular holdings of stocks and shares or a bank or building society account. This is clearly not the right counterfactual; wealthy savers will be seeking the advice of financial experts on the next best alternative to reduce the amount of tax that they have to pay.

 

 

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