IFS: Our complex and poorly targeted system of tax subsidies for pensions needs reform

The current system of pensions tax provides overly generous tax breaks to those with the biggest pensions, those with high retirement incomes and those receiving big employer pension contributions. It does relatively little to support many of those facing low income in retirement, who most need it. Reducing limits on pension saving – the route taken in recent years – is not a good solution: 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.

In a new report, A blueprint for a better tax treatment of pensions, published today and funded by the abrdn Financial Fairness Trust, IFS researchers set out proposals to even out tax support for pension saving – reducing subsidies where they are overly generous and increasing them where saving incentives are weaker.

The reforms would boost the retirement incomes of the bottom 80% of earners and provide greater encouragement for them to save more in a pension, while getting rid of overly generous subsidies that benefit those on high incomes could enable the removal of the complexities created by tapering away annual savings allowances.

The report proposes the following changes:

• Reform the 25% tax-free component to provide a more equal subsidy to all private pensions, benefiting those with a low retirement income. At present, people can take a quarter of their pension free of income tax. While popular, this provides a large tax subsidy to those with high incomes and big pensions but is of no value at all to those with the lowest incomes in retirement: non-taxpayers. At a minimum, the tax-free component should be capped so that it only applies to 25% of, say, the first £400,000 of accumulated pension wealth: this would still leave about four-in-five of those approaching retirement unaffected. 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.

• Give up-front employee NICs relief on all pension contributions, and tax pension income instead. While you get upfront income tax relief on pension savings, you do not get up-front relief from employee NICs on your own contributions. 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. 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.

• Decouple the up-front tax subsidy from employer NICs. Employer pension contributions escape employer NICs entirely. This is a huge tax break but is of no value when employers are not liable for employer NICs – for example, small employers. And every time employer NICs are increased – they only seem to rise over time – the scale of this subsidy increases. We recommend applying employer NICs to employer pension contributions. A new subsidy on all employer pension contributions could then be introduced. Setting the new subsidy at 13.8% would mean that no employer immediately lost from the reform. But a lower rate of subsidy would be possible. For example, a subsidy of 10% would cost around £3½ billion a year less than a 13.8% subsidy.

• Reform the lifetime allowance and end the tapering of the annual allowance. 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, especially for the highest earners, raising taxes by an estimated £8 billion a year. This has 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 government should:

- consider making the annual allowance much more generous and certainly end the policy of tapering annual allowances for very high earners.

- reform and then consider increasing the lifetime allowance. For defined benefit arrangements, it would make sense to set a cap on the pension benefits; for defined contribution arrangements, we propose replacing the current lifetime allowance with a lifetime contribution cap. This would have the advantage of not distorting the investment decisions of those with large pension pots.

This package could be made revenue-neutral in the long run, and even in the short run. There would be an up-front cost to giving relief on employee NICs. It could readily be met by reducing the generous treatment of employer contributions. Revenue could also be raised by applying some NICs to pension withdrawals immediately. Given that those with high levels of private pension income will almost all have enjoyed significant employer contributions on which no NICs were ever paid, there is in any case an argument for such a levy.

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.

Isaac Delestre, a Research Economist at IFS and an author of the report, said:

‘Pension saving is treated generously for high earners. Even under pension caps, over £250,000 can be withdrawn from a pension free of income tax. Employer pension contributions escape National Insurance contributions entirely. And pensions are an easy-to-use vehicle for avoiding inheritance tax. At the same time, the 25% tax-free component is worthless to those who do not pay income tax in retirement. And those making individual pension contributions receive much smaller subsidies.

‘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. This evening-out of tax support for pension saving would be more equitable and more economically efficient, and would allow the current set of poorly designed limits on what individuals can save in a pension to be relaxed.

‘We would retain the current system of up-front relief from income tax that is of much benefit to higher-rate taxpayers. But our proposal to move employee NICs to a similar basis would benefit low and middle earners making individual pension contributions at the expense of higher-rate taxpayers enjoying large employer pension contributions.

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

Mubin Haq, Chief Executive of abrdn Financial Fairness Trust, said:

‘Collectively we save £115 billion a year in workplace pensions, with these savings treated generously by income tax, National Insurance and inheritance tax. But many of these 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.

Today’s report proposes a set of recommendations which would rebalance where our tax reliefs go, with the bottom 80% of earners gaining most from the reforms. This would help deliver greater financial fairness and boost retirement savings for those who need them most.’

Download the report