Craig Rickman, Personal Finance and Pensions Expert, interactive investor (ii): Among the rumours circulating about how Labour might alter the retirement landscape is to equalise upfront pension tax relief.
This isn’t a new concept - previous governments have apparently considered its merits - but it is a controversial one.
Under the current regime, you get tax relief on what you pay into a pension at your marginal rate, whether that’s 20%, 40% or 45%.
Some assert this system already represents fairness. You get relief on the tax you pay on the next pound you earn – no more, no less. Others, however, feel tax relief should be equalised for all taxpayers.
The Fabian Society is the latest to have its say on the matter. In a report titled, Expensive and unequal: the case for reforming pension tax relief, published on 26 August, the think tank urges the government to overhaul the current system in favour of a single, flat rate of either 25% or 30%.
It claims this change, plus other sweeping reforms to pension taxation, would not only create a level-playing field, but could raise £10 billion a year for Chancellor Rachel Reeves – a significant chunk of the government’s apparent £22 billion fiscal “black hole.”
The report came just a day before Prime Minister Keir Starmer warned tax rises are inevitable: “There is a Budget coming in October, and it’s going to be painful,” he said.
Back in June, a spokesperson for Reeves told the Financial Times she had no plans to reform pension tax relief if she became chancellor but failed to rule it out completely.
Needless to say, any adjustments to pension taxation must be handled with kid gloves. Reducing the maximum tax-free lump sum entitlement, removing the IHT and pre-75 income tax exemptions, and applying NI to private pension income may raise revenue for the government, but will erode the appeal of saving into a pension.
And this comes at a time when the government and regulators need to incentivise people to beef up their retirement pots rather than deter them to avoid the UK hurtling towards a looming retirement crisis.
The report’s suggestion to tick up employer contributions under auto enrolment seems sensible, although we should note this would come at an additional cost for workplaces.
It’s widely accepted that a worker who sticks to the current minimums - where employees pay 5% of salary and employers contribute 3% - will fail to accrue a sufficient retirement pot to live comfortably in old age.
A report by pension provider Phoenix Group and consultancy WPI Economics, published in April 2024, calculates that hiking the total minimum to 12% could increase additional pension contributions by £10 billion a year. For an 18-year-old, this would mean their pot is £96,000 bigger - in today’s money - at state pension age.
What are the complications and drawbacks for savers?
There are several stumbling blocks to overhauling the existing upfront tax relief system.
Workplaces that operate a net pay arrangement, where employers take pension contributions from earnings before it’s taxed, would have to be ripped up – potentially causing admin headaches for such schemes.
It also seems salary sacrifice, a popular tactic where you trade a portion of earnings for a pension payment, would disappear. This enables you (and your employer) to also save NI on pension contributions – a big incentive for savers and workplaces.
But the report says that to avoid higher earners using such a strategy under a single-rate arrangement, “identical changes to income tax relief need to be applied to employee and employer contributions. Employer pension contributions would become taxable income, and then the new single rate of income tax relief would apply to both employer and employee contributions.”
A flat rate of tax relief could also pose problems for defined benefit (DB) schemes, which provide an inflation-proofed lifelong income at retirement based on your final or career average salary and number of years’ service. Such schemes have largely been phased out of the private sector over the past couple of decades as they’ve become increasingly expensive to run.
As the Fabian Society reports notes: “Major changes to the tax treatment of DB schemes might trigger the few remaining private sector schemes to close. There would also be significant administrative complexities in changing the tax treatment of employer DB contributions.”
Consequently, the report recommends special arrangements for DB schemes.
The marginal rate relief regime is also useful for those whose income plants them in one of the two tax traps. Those with young children face a charge on child benefit payments once one parent’s income exceeds £80,000, while the personal income allowance – the amount you can earn every year tax free – reduces by £1 for every £2 you earn above £100,000. In both cases, this can result in an effective tax rate of 60% or more.
But as pension payments under the current system allow you to reduce your adjusted net income, you can reduce or even swerve the extra tax penalties. This gives those affected a strong incentive to tuck money away for later life and trim their tax bill at the same time. As the Fabian report notes, a single-rate system would likely limit pension contributions to a top-up or boost, such as “a £1 match for every £3 of contributions after tax”.
What’s more, with tax thresholds set to be frozen until 2028, millions more people are tripping into the 40% bracket. And a key weapon to combat fiscal drag, as it’s known, is to make pension contributions that obtain tax relief at your marginal rate.
A final thought is that while the government has not stated whether it will consider the Fabian Society’s proposals, it’s vital that savers have confidence in the pension system to plan for their retirements effectively. Reeves clearly has some big decisions to make, but chopping and changing pension tax rules, especially if they are detrimental, may damage consumer confidence and ultimately harm engagement.
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