What’s the chancellor’s next move going to be with my pension?
With well-off Brits braced for a “painful” Budget, speculation about future tax rises — and their consequences — has reached fever pitch.
“I call it the Jenga Theory of the tax system,” says tax lawyer Dan Neidle of Tax Policy Associates, referring to the popular game of extracting wooden blocks from a stack.
Our tax system is now so complicated that making changes in one area can have an unexpected impact on another. We discuss many of these on the next episode of the FT’s Money Clinic podcast, which drops next Tuesday, but in this column I will apply “Jenga Theory” to pensions.
For a chancellor looking to find £22bn, pensions are an obvious target, but what kind of game will Rachel Reeves be looking to play? Will she gingerly attempt to extract a bit more tax here and there, or pursue much more sweeping reforms to knock down and rebuild the whole pensions system?
At this stage in the electoral game, she can afford to make some bold moves, but must weigh these against the political risks. And her strategy is not solely about raising tax revenues. Labour’s promise to be the party of wealth creation for ordinary working people (and some might say wealth destruction for the rest of us!) must address the problem of pension undersaving as millions sleepwalk into a retirement crisis.
Let’s start with the fundamental rule of the pensions game — incentivising people to put money aside for their retirement. Ergo, our contributions are not taxed on the way in (up to a limit); our investments can grow tax free; we can take 25 per cent tax free when we retire, but we are taxed on withdrawals.
Unless, of course, your wealth manager has recommended that you “spend the pension last” in the hope of passing it on tax free to your family if you die before your 75th birthday (and it will pass still free of inheritance tax if you die after that).
Ending these tax advantages on defined contribution pensions would be an easy move, and has the added bonus of not affecting high-earning public servants (a prime example of Jenga Theory being NHS doctors retiring early to avoid pension tax charges). However, it is unlikely to raise much money quickly.
The next obvious block to poke is reducing the 25 per cent tax-free lump sum (currently capped at £268,275). Leftwing think-tank the Fabian Society has argued it should be slashed to £100,000. You’d need a pension pot of above £400,000 to be affected by this, which is many multiples of what the average saver has amassed. Yet even if Reeves opted for a more modest cut, there would still be a public outcry because tax-free cash is arguably the most widely-recognised pension benefit.
Another idea is to tax pensions more on the way out by applying national insurance contributions to withdrawals. Technically, this might not break Labour’s manifesto pledge, but pensioners would see it this way — and just look at the level of anger over scrapping the winter fuel allowance.
All of these measures risk denting the attractiveness of pension saving and eroding trust in the system — but what about more radical Budget moves?
Anything really extreme such as unveiling plans to means-test the state pension in future would see Labour’s chances of winning a second term come tumbling down. But there is a strong desire to tilt pensions tax advantages in favour of ordinary working people (which I view as shorthand for basic-rate taxpayers).
Introducing a flat rate of tax relief on pensions contributions would be a huge, complicated change, but the idea is rapidly gaining traction. The nuclear option would be setting this at 20 per cent for everyone, which would save multiple billions. But taxing contributions on the way in and the way out could cause higher-rate taxpayers to question the logic of pension saving altogether, and frozen income tax thresholds mean millions more people are set to join this club.
A less stingy flat rate of 25-30 per cent would be more palatable, and some might say fairer, giving basic-rate taxpayers a government top-up to boost their pension pots (technically, it’s not tax relief). But there could be other distorting effects. For example, could workers on the cusp of the higher-rate tax threshold turn down extra shifts or a promotion through fear of losing this perk?
And what about the growing number of professionals entering the so-called six-figure salary trap? Many try to avoid the punitive 60 per cent marginal rate on income between £100,000-£125,140 as the personal allowance is removed by deploying a Jenga move of their own — sacrificing pay to their pension. This group would be significantly worse off, and even more so if they also lost entitlement to childcare benefits.
A flat rate could also create nasty tax consequences for public sector workers paying into defined benefit schemes. Experts think separate rules would be needed, which would undoubtedly prompt cries of unfairness and pandering to trade unions.
To help lower earners save more, Tom McPhail at the Lang Cat, a pension consultant, wouldn’t be surprised if Labour forced employers to pay more into worker’s pensions. Under auto-enrolment, they currently pay a minimum 3 per cent of qualifying earnings, yet employees must pay 5 per cent.
While this policy has swept 10mn into pension saving, most people still aren’t saving enough, and plenty fall through the cracks — notably the self-employed and low-earning women. The gender pensions gap affects higher-earning women too, with more than half expecting to run out of money in retirement, according to Fidelity’s latest Women and Money study. Playing devil’s advocate, should Reeves consider an additional incentive for these groups to save?
Conversely, she could charge employers national insurance on staff pension contributions. Employers pay much higher rates of NI (13.8 per cent) and the widespread use of salary sacrifice arrangements at big companies means they avoid paying it on a good chunk of the wage bill.
But what effect would extending this so-called “tax on jobs” have on the employment market, not to mention UK GDP? Private sector employers would undoubtedly react by offering staff less — but Reeves may not be overly concerned. Tax relief on employer pension contributions makes up 84 per cent of the total, according to the Fabian paper.
Helping lower earners save more is important, but if we achieve this by blighting the retirement prospects of other hard-working people then trust in the pensions system may never be rebuilt. As someone who has diligently saved into a pension for decades, and actually intends to spend it in retirement, I will be furious if my prudence ends up being punished.
Whatever policy direction Reeves pursues, she should bear in mind what happens if you rush a game of Jenga.
Claer Barrett is the FT’s consumer editor; [email protected]; X @Claerb; Instagram @Claerb