Editor's comment: The Lifetime Allowance is a tax on prudence and investment success, and it is high time it was done away with.
For the past two decades or so, as final salary schemes have declined and it has become increasingly clear that the state pension alone will be barely enough to scrape by on, we have been exhorted by the powers that be to take control of our own financial destiny.
Auto-enrolment now ensures that the vast majority of employees set aside money regularly for their later years – but there has been growing awareness that people generally need to engage more actively with the whole business of building a pension if they are going to enjoy a comfortable retirement. That means two things: putting away more than the minimum contribution, and then thinking carefully about how it is invested.
Unfortunately, as Jeremy Poland’s letter running in the letters page of our November edition spells out very clearly, those who take up the challenge have an additional handicap due to the government repeatedly shifting the goalposts. It’s the most assiduous pension investors who have been punished most brutally through a series of changes to the value of the lifetime allowance (LTA) for pensions, coupled with an inherently unfair twist in the way it’s structured.
The LTA was introduced in 2006 by the then chancellor Gordon Brown as a means of raising revenue for the Treasury: pensions worth more than the cap (initially £1.5 million) are heavily taxed on the margin when the money is taken out. The threshold was hiked to £1.8 million in 2010, but has since been progressively whittled away to boost the Treasury coffers, falling to £1 million in April 2016 and now sitting at £1.03 million. If your pension breaches the LTA, you’ll pay up to 55 per cent on the excess, depending on how you withdraw it.
So far the sums raised by the Treasury this way have been pretty modest – most recently, £102 million in 2016/17. But experts expect those sums to rise over time as more higher earners build career-long defined contribution pensions.
Our reader’s experience highlights the inherent absurdity of the whole arrangement. In his efforts to plan ahead and make best use of the incentives for long-term pension saving, he has suffered a double whammy from these changes. He’s now being penalised not just by the government’s short-termist approach and change of heart over LTA levels, but by the fact that he’s taken the trouble to become a successful, engaged, Money Observer-reading investor.
In effect his investment choices have done too well. As a consequence, he has breached the reduced cap, despite the fact, as he bitterly observes, that he never exceeded the contribution limits.
The situation regarding his son’s pension is potentially even more unfair. For 15 years Mr Poland has tucked away the full £3,600 a year, including 20 per cent tax relief, into a stakeholder pension now worth around £40,000. That means HMRC has contributed £10,800 (15 x £720) in tax relief. Yet even if no further contributions are made at all (assuming an average 8 per cent growth per year), his son’s pension pot will be worth more than £1.35 million by the time he reaches the age of 60.
In such circumstances, having saved many thousands of pounds of pension tax relief over several decades of non-contribution, it would seem reasonable for HMRC to forego applying the LTA penalty to the pension. But as things stand, assuming the rules don’t change and the excess is then taken as a lump sum and taxed at 55 per cent, the Treasury stands to cream off a further £200,000 or so when the pension is accessed, thanks purely to the investment success of the Polands senior and junior.
Interestingly, at just 5 rather than 8 per cent annual growth, the pot would be worth only £330,000 at age 60 – a brilliant example of the power of compounding, not to mention the potential benefit of actively choosing decent and consistent funds and monitoring them over time.
Of course, there is a good argument for limiting the amount of pension tax relief available to an individual, but an annual limit on contributions will achieve that. The LTA is a tax on prudence and investment success, and it is high time it was done away with.
The Treasury Select Committee said much the same thing in its July report on household finances, in which former pensions minister Steve Webb described the LTA as ‘a cap on success’; it called for the government to give serious consideration to replacing it with a lower annual allowance. However, I’m not going to hold my breath for chancellor Phillip Hammond to do away with the LTA in the upcoming Budget. Never mind the fact that it’s fundamentally unfair – it’s a useful source of income at a time when he needs all the cash he can lay his hands on for the National Health Service.
Assuming no budgetary LTA shake-up, we’ll take a closer look at how to manage the pension contribution limits in a coming issue of Money Observer.