Friday, January 22, 2016

Pensions - the unfairness explained

Setting aside any political motivations for the introduction of flat-rate tax relief on pensions contributions, we should appreciate the unfairness of the current system. Journalists typically give the following types of examples to explain the current situation:

Basic rate tax payers currently need to put in 80p for every pound that goes into their pension, as they get 20% tax relief. Middle rate tax payers, who pay an income tax rate of 40%,  need to put just 60p in for every pound. Lastly, those in the highest income tax bracket (i.e. at the 45% tax rate) need to put in just 55p for each pound that goes in to their pension.

I think that it is misguided to look at the percentages from this perspective. Instead, lets see what happens when we view the rebates in a rate of return context, i.e. how much does your contribution grow by as a result of the relief.

Low rate: 80p to £1 is day-one gain of 25%
Middle rate: 60p to £1 is a day-one gain of 67%
High rate:  55p to £1 is a day-one gain of 82%

This clearly shows how distorted things are and it explains why the highest rate tax payers have a much greater incentive to stuff their money into a pension: not only do they have a lot more spare money but they are offered a rate of return that is more than three times the rate available to low rate tax payers. The distortions skew incentives even more under the new pensions regime, as pensioners are no longer forced to buy low-rate annuities on retirement and can take 25% of their pension pot tax free at the age of 55. In effect, high rate tax payers can treat a portion of their pension more like a long-date bond with unbelievable returns.

It's a greet wheeze that nobody can be blamed for taking advantage of, but things do need to change. Come the March Budget, it will be interesting to see if the chancellor merely rebalaces the system with a single tax-relief rate for all (e.g. 30% relief, which works out to a gain of almost 43% on all contributions), or whether the government sneakily uses the overhaul as an opportunity to raise tax revenue by introducing a much lower rate.

We'll revisit this post once the budget details are confirmed.

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