As the current government’s term draws to a close, it’s an opportune moment to reflect on the UK pension system. Over time, our current system has become increasingly complex due to piecemeal changes, often driven by the need for the government to find additional funds – and a comprehensive pension review under a potential new government offers a strategic chance to think holistically about the system and provide some welcome medium-term stability.
One key focus of a government pension review is likely to be the issue of tax relief. However, with both Labour and the Conservatives committed to maintaining current income tax levels, national insurance contributions and VAT rates, finding new revenue sources may prove challenging: pension tax relief costs tens of billions of pounds annually, making it an obvious target for a government looking to make savings.
Reforming pension tax relief will also require clarity on the end goal. Fiscal purists simply view tax relief as a way to shift tax from the earning phase to the retirement phase – making it fiscally ‘neutral’. However, other forms of tax relief – such as tax-free lump sums or inheritance tax exemptions – are less so.
Alternatively, pension tax relief could incentivise pension saving, particularly for lower and middle-income earners, who might otherwise be left with modest retirements. A commonly suggested reform would be implementing a flat rate of pension tax relief, regardless of the individuals’ level of income.
This approach would address the current system’s imbalance, where higher earners benefit the most. What’s more, a flat rate could be revenue-neutral or even provide a net gain to the Treasury, while supporting lower earners more effectively.
On the other hand, some argue basing tax relief around a flat rate would further complicate an already complex system, especially for public sector workers with defined benefit (DB) pension schemes. A radical approach might involve separate systems for DB and defined contribution (DC) pensions.
With fewer private sector workers accruing DB rights, future DB pensions will primarily be geared towards the public sector. Reforms could include adjusting contribution rates based on income or reducing the generosity of public service schemes to raise funds without complicating tax relief.
When it comes to DC pensions, starting afresh would allow for radical reforms. For example, the incoming Treasury could choose to rebrand tax relief as a ‘government incentive’ that’s geared towards incentivising lower earners.
This could involve a tiered matching system where government contributions decrease as individual contributions increase. For example, the government could match the first £5,000 of savings pound-for-pound, then offer a lower match rate for additional savings, simplifying pension saving and making it more accessible for those earning less.
The relief at source method, used by personal pensions and schemes like Nest, is already (in many respects) a form of matching. Contributions are made from take-home pay, with the government adding basic rate relief directly to pensions, whilst higher earners can claim additional relief via tax returns.
Rebranding these payments as government matches – and eliminating higher rate relief claims – could streamline the system and better incentivise low and middle-income earners to save for retirement.
Of course, having distinct regimes for DB and DC pensions would bring its own set of challenges, such as handling DB to DC transfers and hybrid schemes. However, with the right approach and careful planning, these issues could be manageable – and potentially result in a more effective system than has been achieved through incremental reforms in recent years.
Source: Webb, Steve. FT Adviser. June 2024. https://www.ftadviser.com/pensions/2024/06/17/election-could-create-an-opportunity-for-radical-shake-up-in-pensions/