Pensions have been in the news this week following the publication of a Government discussion paper on restricting pension tax relief. Frankly it’s old news as it simply tells us what we already knew from the emergency Budget – the Government proposes to remove tax relief on pension contributions above an annual allowance of between £30,000 and £45,000. But it’s quite an important move and while unpopular, necessary given the state of our public finances. Let’s look at the implications in more depth, along with a couple of other recent proposals.
Annual pension allowance of £30,000 - £45,000
The previous Government planned to reduce higher rate tax relief on pension contributions to basic rate for those earning £150,000 or more a year (including employer pension contributions), with a view to saving the public purse £3.6 billion a year by 2013-14.
While a fiscal necessity, the approach was complicated so replacing this with a simple annual contribution allowance makes far more sense.
The new Government’s proposal is to instead reduce the annual limit for pension contributions that enjoy tax relief from a current level of £255,000 (or annual earnings, whichever is lower) to between £30,000 and £45,000 – with £40,000 appearing the favoured level. Contributions above the allowance would suffer a tax charge that effectively removes the relief.
The Government also seems keen to cap the maximum rate of tax relief at 40%, bad news for 50% taxpayers but good news for public finances as it’ll net an estimated £500 million a year in savings.
Unless you make hefty pension contributions the changes are unlikely to affect you...unless you have a final salary pension.
This is where it gets a bit more complicated. If you’re in a final salary pension there’s no explicit annual contribution, so HMRC instead treats it as being £10 for every £1 your pension at retirement increases over the year. So if your pension entitlement increases by £2,000 your annual contribution is deemed to be £20,000 (for the purposes of the annual allowance).
The Government thinks a factor of 10 is too low and is keen to raise it to 15-20. So assuming a £40,000 annual allowance and factor of 20, annual pension increases above £2,000 could mean you losing some tax relief.
For example, if you have 30 years’ service in a 1/60th pension scheme and your salary increases from £45,000 to £48,000 your deemed annual contribution would be over the limit (30/60 x £45,000 = £22,500 pension. 31/60 x £48,000 = £24,800 pension. Pension increase = £2,300, so deemed annual contribution = £46,000).
There’s also a hint that the Lifetime Allowance, currently £1.8 million, might be reduced to £1.5 million, potentially affecting those with very large pension pots (or final salary pensions) at retirement.
We can expect final announcement by the end of September with any changes coming into force from 6 April 2011.
Final salary pensions to increase by CPI not RPI
The emergency Budget saw the Government announce that public sector pension increases would be linked to CPI rather than RPI from April 2011. And it confirmed the fate for private sector final salary schemes earlier this month.
This is a blow if you’re in one of these schemes, as CPI tends to be lower than RPI due to excluding housing costs such as mortgage payments and council tax. But with both government and private sector final salary schemes in financial dire straits it’s hardly a surprise.
How much could this affect you? Let’s assume long term CPI of 2%, RPI of 3% and a pension of £20,000 at age 65. Linked to RPI you’d have received total pension income of £688,529 by age 88. Linked to CPI it would be £608,437, about 10% less.
Scrapping the retirement age
The Government is also planning to scrap the default retirement age of 65, taking effect from October 2011. Don’t panic, it doesn’t affect your state pension; just means employers can no longer force you to retire at 65.
There’s little doubt that one way or another it’ll get tougher to enjoy a decent income during retirement – unless you keep working. While retirement planning is easy to delay or ignore, it really is a good idea to work how you’ll cope well in advance.