Budget 2016: Pension Isa is frontrunner for pension tax relief overhaul

4 March 2016

With the Budget less than two weeks away, chancellor George Osborne is said to be favouring a variation on the pension Isa theme, which reduces or ends front-end tax relief and instead allows investors to make withdrawals from their pension pots free of tax.

But the idea - the most radical option under discussion in the government's pension tax relief consultation - has sparked grave concerns among industry commentators.

A new report by the International Longevity Centre (ILC-UK) warns against pensions reform that would provide less incentive for people to save for the long term. Under the Pension Isa system, tax is paid upfront and income is received tax-free (a TEE or taxed/exempt/exempt system).


Pension saving could become stifled

The report cites research showing that under such an arrangement, not only would individuals be less inclined to save into their workplace pensions, but employers seeing that trend would also place less value on employer contributions.

It throws up the "very real" risk that a TEE system would effectively stifle pension saving, as people would not trust the government to stick to its promise of tax exempt withdrawals 40 years down the line.

"We fervently hope that all the talk about moving towards an Isa-style pensions system with contributions made after tax remains just that - talk: we are wholly unconvinced that such a scheme would benefit this or future generations and are extremely worried that it could, in fact, put off lots of people from saving for a pension at all," says Caroline Abrahams, charity director at Age UK, which supported the report.

Tom McPhail, head of pensions research at Hargreaves Lansdown, agrees with that concern.

He adds that perhaps the biggest risk would be that once they hit 55, people would be free to empty their pension pot at the drop of a hat, or the change of a pension regime, with no tax considerations to discourage them from doing so.

That would mean "the risk of a future Nrthern Rock-style run on the pension system and the UK stock market. Any hint of political interference in the future could result in billions of pounds being withdrawn overnight; it would be hugely unstable," he says.


Annual allowance cut

The chancellor's latest thinking is to move to a system of 20% tax relief plus tax-free withdrawals, according to a Treasury leak to the Telegraph.

Superficially, this could look quite attractive, with some tax relief on the way in and tax-free income on the way out, but there are various problems with it, says Mr McPhail.

"This is likely to be particularly bad news for anyone who becomes a higher-rate taxpayer towards the end of their working careers when they are most able to catch up on their pension funding," he explains.

"It would mean cutting the annual allowance very substantially, probably down to around £10,000 [given that withdrawals would be tax-free]. It would therefore become extremely difficult for mid to high earners to build a decent retirement pot over their working lives.

"For a higher earner, it would mean exchanging 40% relief on £40,000 for 20% relief on £10,000; a loss of £14,000, in exchange for a paper promise from a politician which would depend on a future government for its honouring."

Two-tier system

The likely consequence would be a shift by higher-rate taxpayers towards riskier investments offering more generous up-front tax breaks, such as venture capital trusts and enterprise investment schemes - a trend that has already taken hold, according to IFAs.

Moreover, in practical terms the change would have to apply only to future contributions, creating a two-tier system and a generation of people receiving tax exemption on only part of their pension withdrawals - "increasing costs and complexity for all involved".

The postponement of tax relief would effectively leave it as a cost to be picked up by future chancellors and generations of workers - who are already seriously financially disadvantaged relative to their parents and grandparents.

Steve Webb, the former pensions minister and now a director at Royal London, also cautions that a Pension Isa could be disastrous for retirement saving.

"The damage done to pension saving would be incalculable, as pensions are once again seen as a convenient pot for cash-strapped chancellors," he says.

However, Mr McPhail adds that his impression is that the chancellor is so far still making up his mind. "This announcement feels as though he is flying a kite to gauge the reactions, and it's not yet a done deal," he says.

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