Let’s start at the beginning. What’s the point of a pension? We all know the answer to that question from a saver’s point of view: we use pension wrappers so that we can save tax-free for our retirement.
As far as we are concerned, the more tax relief the better, as more relief means more money to spend in our old age. But look at it from the point of view of the state, and things are different.
The state doesn’t offer tax relief on pension savings because it wants voters to drift through their twilight years on a series of Crystal Cruises. Far from it. For the state, the point is to bribe us into saving enough to guarantee that we won’t be a burden in our old age. But that’s it.
Look at it like that and you will see what is going on in the world of pensions regulation at the moment. What’s the point in offering tax relief on savings beyond the level required for basic living? Doing so is a luxury we just can’t afford. More relief just means more deficit.
That’s why the lifetime allowance (LTA) has just been cut again. At its peak it was £1.8m. Now it is to be a mere £1m. You might think this is reasonable in light of the financial pressures that George Osborne lives with. But it isn’t. It’s absurd.
That’s because the LTA isn’t what most people think it is. It isn’t a limit on the amount of money you can contribute to a pension over a lifetime. It is the amount you can have in your pension when you retire — with the excess taxed at a rate of 55% on anything taken as a lump sum, and 25% on top of your marginal rate of income tax if taken as income (if you are a higher rate taxpayer, it is also 55%).
That makes a huge difference, because while you can keep track of how much you put into your pension, you can have no possible idea of what it will be worth in ten, 20 or even 30 years. That will depend on the returns you make on the money. So pensions saving — for anyone moderately well-off — turns into a long-term and very trying guessing game.
Let’s say that you are 35, have £350,000 in your pension scheme and plan to contribute £500 a month until you are 55. Given that you are £650,000 shy of a million quid, you probably aren’t remotely worried about the LTA.
You should be. If your pot grows at 5% (in real terms) a year, the magic of compounding means that you’ll have £1.13m when you retire. Whoops. And that’s not accounting for inflation. Osborne says that from 2018 the LTA will be indexed. But there’s a pretty good case for discounting this promise on the basis that (a) it is three years away, and (b) governments love cancelling indexing — it’s easy and it’s lucrative.
So let’s add on an average rate of inflation at 3% a year. Now, 20 years on, you will have a total pot of not far off £2m. Whoops again. Perhaps you should apply for LTA protection?
All previous cuts to the LTA have allowed savers to lock in the previous rate of LTA (which will now be £1.25m) for themselves as long as they promise to save no more into their pensions. That figure of £1.25m won’t save you that much in tax when you suddenly find yourself with £2m. But it’s better than nothing.
There’s more. You can’t forget about the LTA even when you actually retire. That’s because your pension is assessed relative to the prevailing LTA (or whatever you locked in at) every time there is what HMRC refers to as a ‘benefit crystallisation event’ (BCE).
If you retire with £1m at 60 and withdraw £250,000 (withdrawing money is a BCE), you are considered to have used 25% of your LTA. You have 75% left. Let’s then assume that you leave the rest inside your pot and it grows at 5% a year for another ten years. Then you’ll have £1.2m. But an LTA of only £750,000 and another whack of tax to pay. Tricky, isn’t it?
But never let it be said I only bring you bad news. I have been looking into what counts as a BCE. Withdrawing money is a BCE. Dying before age 75 is a BCE. And your 75th birthday is counted as yet another a BCE. But Hargreaves Lansdown tells me that dying after your 75th birthday is not a BCE.
Added to the fact that the pension reforms allow you to leave your fund to whoever you fancy, free of inheritance tax, this is excellent news. Let’s say you regularly withdraw money from your pension until you are 75 to keep it just under £1m. You then don’t touch it again. You die aged 88. Now you have £1.9m. And you can leave it all to whoever you want IHT-free (your heirs pay their marginal rate of income tax on withdrawal).
How’s that for estate planning?
I’m not suggesting you devote much effort to avoiding IHT like this: there’s huge political risk and, no doubt, complications I haven’t thought of. But I do want you to read this, realise how nuts the whole LTA thing is, and write to Mr Osborne to complain — and to point out that if he must cut pension tax relief, it would be an awful lot easier to put a lifetime limit on actual contributions.
You might also add that this chipping away at the LTA is deeply unfair. The way it is applied to defined-benefits pensions means that those people lucky enough to have them get double the tax-free income the rest of us can have before they hit the punitive tax threshold. And the differing LTA protection limits mean that older, well-off people have had access to tax relief levels that the rest of us can now only dream of. It’s all wrong.
• This article was first published in the Financial Times.