The UK pensions tax system is too generous to certain groups and does not support those who need help the most, the Institute for Fiscal Studies has said in a new report, proposing major reforms. 

  

The current pensions tax system does little to support people that will have low incomes in retirement, the report, ‘A blueprint for a better tax treatment of pensions’, funded by the abrdn Financial Fairness Trust, has found.  

Reducing limits on pension saving such as the lifetime and annual allowances “is not a good solution”, the researchers say, as it does nothing to support low earners, adds significant complexity and leaves subsidies that are still too generous for some. “A long-term vision for the system is needed,” the IFS says.  

  

Isaac Delestre, IFS research economist and an author of the report, said too much of a pension can be taken tax free, and pensions now also serve as a way to avoid inheritance tax, while the 25% tax-free lump sum is worthless for those who do not pay income tax in retirement.  

  

"Our proposals would boost the retirement incomes of low and middle earners and provide greater encouragement for them to save more in a pension. They provide a coherent vision for the taxation of pensions and don’t require the complexity, and big losses for some current basic-rate taxpayers, that would result from restricting income tax relief to the basic rate, for which some have argued,” Delestre said.  

  

“Our system of pensions taxation has too many features that are arbitrary, wasteful or unfair. It’s long past time we retired them,” he added.  

  

Many pensions tax reliefs are more generous to those with the largest pension pots, whilst millions of those on low to middle incomes are likely to fall far short of the retirement savings they need to support them in old age, said Mubin Haq, chief executive of the abrdn Financial Fairness Trust.  

  

“Today’s report proposes a set of recommendations which would rebalance where our tax reliefs go,” Haq said.  

  

The authors of the report are proposing reforms that they say would boost the retirement incomes of the bottom 80% of earners and provide greater encouragement for them to save, while getting rid of subsidies that benefit those on high incomes. It could also reduce the complexity created by tapering away annual savings allowances, they argue.  

  

Their proposals are:  

  

  

The IFS says that although this perk is popular, it provides a large tax subsidy to those with high incomes and big pensions but is of no value to those who do not pay tax in retirement. Therefore, they say the tax-free component should be capped so that it only applies to 25% of a certain amount, e.g. the first £400,000 of a pension pot.   

   

“Going further, we propose replacing the tax-free component with a new subsidy. This could be designed to be as generous as the existing system to basic-rate taxpayers but to provide equivalent support to non-taxpayers and to stop providing more generous support to those paying higher-rate income tax in retirement,” the researchers said.  

  

  

The authors note that while pension contributions are relieved of up-front income tax, employees pay national insurance on their pension contributions. Meanwhile, pensioners currently do not pay national insurance on their pension income.  

  

“Up-front relief equivalent to the rates of employee NICs should be extended to all pension contributions and we should gradually move to a system where all private pension income is subject to employee NICs,” the economists argue, saying this would align the income tax and employee NICs systems and would benefit low and middle earners who make individual contributions, at the expense of higher earners enjoying big employer pension contributions.  

  

  

Employers are relieved of NICs entirely on pension contributions they pay for staff, but again small employers that fall below the NICs threshold do not benefit, a disparity that increases as NICs rise.  

  

The IFS therefore recommends applying employer NICs to employer pension contributions. Instead, a new subsidy on all employer pension contributions could then be introduced, it proposes.  

  

  

The lifetime and annual limits on the amount that can be saved free of income tax in a pension have been cut sharply since 2011. While raising taxes by an estimated £8bn a year, these policies have “created complexity and damaging disincentives for an increasing number of higher earners. Since the other reforms we propose would get rid of the excessive generosity in the current system, they would allow policymakers to be more relaxed about these limits,” the IFS believes. 

It said the government should consider making the annual allowance much more generous and should end the tapering for very high earners.  

 

It also wants to see an increase in the lifetime allowance, saying that for defined benefit schemes, there could be a cap on the benefits, while for defined contribution, the current allowance could be replaced with a lifetime contribution cap so DC savers are not penalised if their investments perform well.  

 

The reforms it proposes could be made revenue-neutral in the long and even in the short run, the researchers believe. The up-front cost to giving relief on employee NICs could be met by reducing the generous treatment of employer contributions, and revenue could be raised by applying some NICs to pension withdrawals immediately.   

  

“Real reform has been stymied for too long by a concern to avoid changing the way that pensions in payment, or soon to be in payment, are treated. There is a strong case for implementing a better system swiftly rather than allowing overly generous elements to linger for longer, typically to the benefit of older generations at the expense of subsequent generations,” the IFS said.  

The Pensions and Lifetime Savings Association agreed with some of the proposals put forward, and highlighted its own paper published in July 2022, 'Five principles for pension taxation', which are promoting pension adequacy, encouraging the right behaviours, being fair to savers, being simple to adopt and administer, and being enduring and sustainable. 

“We agree with the IFS that it makes sense to keep the UK’s long-established system of providing up front tax relief, the 'EET' system," said Nigel Peaple, director of policy and advocacy. Changing this could not be done in a fair way and would undermine confidence in the system, he argued, leading to less saving.

The association also welcomes measures to encourage and incentivise the self-employed to save into a pension, and the IFS’s proposals to change the way in which the lifetime allowances for DB and DC pensions should be measured.

Increasing the burden on employers, on the other hand, is not landing well at the PLSA. 

“The PLSA is concerned that applying taxation to employer contributions, even if replaced by a variable subsidy, might discourage employer pension payments," Peaple said. 

The PLSA also disagrees with reforming the 25% tax-free lump sum, saying this "would reduce a very popular and widely understood element of the pensions tax regime”.

 

The Association of British Insurers agreed with the need for reforming the system, emphasising however that industry should be consulted. 

 

“We agree that a long-term vision for the pension tax relief system is needed, rather than constant tinkering. We also agree that up-front tax relief should be maintained, and consideration given to reforming the rules to offer more support to low and middle earners,” said Yvonne Braun, director of policy, long-term savings, health & protection. 

 

Braun called for scrapping the money purchase annual allowance – which cuts the DC annual allowance from £40,000 to £4,000 once a pot has been accessed – saying policies like this put people off saving and add complexity. 

 

“It is vital that any reforms to pension tax relief aim to build long-term stability and increase the trust savers have in pensions. Any changes must be made for both defined contribution and defined benefit pensions, and in consultation with industry,” she added. 

 

‘A blueprint for a better tax treatment of pensions’ is the second and final report of a project on reforming pensions taxation. The first report, ‘Death and taxes and pensions’, dealt with tax treatment at death.