Reform of pension tax relief

Looks at the debate on pension tax relief reform

The principle of the current system of tax relief is that contributions to pensions are exempt from tax when they are made, but taxed when they are paid out to the individual. Pension contributions made by individual employees are usually paid out of pre-tax salary, so tax relief is received at their marginal tax rate. The main limits that apply are the lifetime allowance (LTA) and annual allowance (AA). (Finance Act 2004 (FA 2004), Part 4).

At introduction in 2006, the AA was set at £215,000 and the LTA at £1.5 million. Both were set to increase in stages, with the LTA reaching £1.8m and the AA £255,000 by 2010. (FA 2004 s218 and 228). Since 2010, both allowances have been reduced in stages, which has reduced the proportion going to higher earners and contained costs (Cm 9102, July 2015, para 1.5 and 2.6.) For more detail, see Library Briefing Paper CBP 5901 Restricting pension tax relief (Feb 2020).

One criticism of the current system is that it is not an effective incentive for those most at risk of not saving enough for their retirement. The Government consulted on reforms to strengthen the incentive to save in July 2015. Debate focused on:

• A shift to a single-rate of relief, possibly rebadged as ‘matching contributions’ from the Government. Advocates of this approach said it would improve incentives to save for low earners and – depending on the rate at which it was set – could reduce Exchequer costs. However, there are concerns that it would be complex to administer for defined benefit (DB) schemes.
• Moving to a TEE (taxed-exempt-exempt) system where contributions are made out of taxed incomes (and then topped-up by the Government) while investment returns, and any income ultimately received, would be tax-free. Advocates say this could allow individuals to better understand the benefits of contributing to a pension and make the Government’s contribution more transparent. Others argue that it would be very complex in transition, could undermine pension saving and have a negative fiscal impact.  
• Retaining the current system with some modifications, for example regarding the LTA and AA. This would have the advantage of lower implementation costs, meaning that reforms could be delivered quickly and with minimal risk.

However, in Budget 2016, the Chancellor said he was not announcing any fundamental change. on the grounds that there was no consensus (HC Deb 16 March 2016 c966).

Calls for reform have continued. In July 2018, the Treasury Select Committee said that the Government should give serious consideration to “replacing the lifetime allowance with a lower annual allowance, introducing a flat rate of relief, and promoting understanding of tax relief as a bonus or additional contribution” (HC 565, para 117). In October 2019, the Office of Tax Simplification recommended that the Government look again at a number of issues: the difference in outcome between net pay and relief at source schemes for people whose income is below the personal allowance; how the annual allowance and lifetime allowances deliver against their policy objectives; and the operation of the Money Purchase Annual Allowance.

In the Budget on 11 March, the Government is expected to report on its review of the impact of the tapered annual allowance on the delivery of public services such as the NHS. This is discussed in Library Briefing Paper CBP 8626