Its hard to remember the last time a Chancellor’s budget has been so hotly anticipated.  With an end to weeks of speculation almost in sight, we take a look at some of the pensions tax changes reported to be under consideration, and what they could mean for public service pension schemes.

As the SPP notes in its recent paper “Pensions Tax Relief – separating fact from fiction”, the changes that the Government made to the tapered annual allowance a few years ago had significant – and unintended – consequences for the NHS Pension Scheme in particular.  Senior clinicians left the workforce in droves, and the impact of those seemingly unforeseen departures ultimately led to a revision of the allowances. 

With further changes to pensions tax in this Budget now seeming very possible, leading voices the industry over are calling for the Government not to rush into alterations this time without giving thorough consideration to all the ramifications – including in particular the impact on public service pension schemes and their membership.

Tax relief on pension contributions

Last month, the smart money was on the Chancellor making changes to the rate of tax relief on member pension contributions.  As a reminder, currently members receive tax relief on pension contributions at their marginal rate – for a higher rate tax payer this is 40%.  The press report that Rachel Reeves has long favoured a move to a single flat rate of relief of e.g. 20% - representing a loss to high earners but a windfall for lower rate tax payers and this looked to be under active consideration in early September. 

However, the position seems to have moved over the last few weeks and this plan is now reported to have been dropped.  A key reason is the impact on high earners in (largely public sector) DB pension schemes, who would potentially find themselves on the receiving end of some high tax bills as a result.  The SPP report gives the following very helpful example (emphasis added): 

“Consider a headteacher earning £80,000 a year with benefit accrual under the Teachers’ Pension Scheme of 1/57th of annual earnings. This means the headteacher will accrue £1,403.51 of pension per annum. 

Using HMRC’s Annual Allowance factor of 16 to value this pension accrual, and ignoring any inflation adjustments, results in a total deemed contribution of £22,456. Limiting tax relief to a flat rate of 25% (say) would mean that a 15% tax charge would apply. Therefore, the total tax charge for a switch to flat-rate relief at 25% for such a headteacher would be £3,368 (or £280 a month). This charge would apply in addition to any contributions that the headteacher is required to pay towards the cost of their pension.”

The IFS has pointed out that moving to flat rate tax relief on pension contributions would also bring more people into higher rate tax bands “if their (and their employer’s) pension contributions were no longer excluded from tax.  For example, an experienced nurse earning £45,000 would typically get an employer pension contribution that the government values at an additional 23.7% of salary – more than £10,000 a year. Given that valuation, about half of the pension contribution would fall into the higher-rate income tax band, leaving the nurse with an additional tax bill of about £1,000 a year if relief were restricted to the basic rate.”

Changes to employer NICs on pension contributions

On the other hand, a proposal that seems to be gathering momentum is the removal of tax relief on employer National Insurance contributions – this has been put forward by the IFS amongst others.  This could be particularly burdensome for employers in the public sector, where schemes remain largely DB and therefore contribution rates are high.

As a reminder, employer pension contributions are not currently subject to NICs.  The current rate of NI paid by employers on earnings over £175 is 13.8% (though it is widely rumoured that this will increase as part of the Autumn budget).  An immediate move from 0% to 13.8% would be a significant additional burden for employers to bear – particularly in the public sector where employers have less flexibility to adjust their pension offering to offset increased costs than employers in the private sector have.  Former Pensions Minister Sir Steve Webb is one of those advocating for a graduated, phased approach if the Government does decide to bring in NICs on employer pension contributions, as is the IFS, which notes that a “big bang change” would risk a “large decline” in contributions to pensions.

Capping the PCLS

Also apparently under consideration is a change to the amount of tax free cash a member can take as a lump sum at retirement (the PCLS).  This will be of particular interest to public service pension schemes as the value of DB benefits can be very high, resulting in significant PCLS payments.  Plus many members have protected lump sum benefits. This can be the case even if they are not especially high earners, particularly if they have a long period of service in the scheme, due to the way in which DB benefits are valued. 

Currently, the maximum tax free cash a member can take at retirement (unless they have a higher protected lump sum) is £268,275.  The PCLS is one of the best understood and most popular benefits amongst members in a complex pensions system so any move to change it by e.g. reducing the cap is likely to be politically sensitive.  And although on the face of it capping PCLS at e.g. £100,000 seems to fit with the Labour policy of the wealthiest bearing the biggest burden, in practice mid level and long serving public sector employees may well be affected.

Taxation of death benefits

One further change reported to be under serious consideration primarily affects DC savers so will only be relevant to a limited extent to public service pension schemes (e.g. in relation to DC AVC pots).  The Government is reported to be considering a move to change the current favourable tax treatment of unused DC pots on death.  The changes may include introducing inheritance tax on unused DC pots, or by ending the distinction between deaths pre and from age 75 (currently survivors only pay income tax when accessing the unused DC pot where the member died on or after reaching age 75). 

The current industry consensus seems to be that this low hanging fruit is ripe for the picking and that a change may well be announced next week.

Comment        

Rumours continue to swirl and we will have to wait until Budget day to find out exactly what the Chancellor has in store for pensions tax (and what the impact might be for public sector schemes).  However, in the context of a pensions landscape where adequacy of retirement savings is a key issue for many, and where the Government will not wish to drive unwanted behaviours such as early retirements of senior public sector employees, one would hope that any changes to pension tax are evolutionary rather than revolutionary.  And that they are implemented over realistic and sufficiently generous timescales with a clear plan.

This article is current as of 23 October 2024.