Pensions Reform: It's time to take a good long look at the pension tax regime

24 May 2023

The scrapping of the lifetime allowance (LTA) and increasing of the threshold for annual allowance (AA) from £40,000 to £60,000 announced in the Budget begs the question: what behaviours are we trying to encourage with pensions tax changes?

There are three certain behaviours:

Ensure continued pension contributions

In the case of the NHS' most senior clinicians, it is very clear that we need more of them to carry on working for longer within the NHS to help chip away at those waiting lists. An article entitled ‘The long goodbye? Exploring rates of staff leaving the NHS and social care', published by the Nuffield Trust in February 2022, found that for hospital consultants in particular, pensions taxation was a key issue. Half of those who had made definite plans to leave the NHS reported pensions tax to be a major factor in their decision to leave.

Furthermore, the British Medical Association found that, in repeated surveys it ran over recent years, the pensions taxation was one of the major factors causing doctors to either retire early or reduce their hours. They have been calling for the pension taxation system to be urgently reformed following Rishi Sunak's decision to freeze the LTA until 2025/26 back in March 2021.

If the pensions tax regime needs to encourage more of us to keep on working, as Jeremy Hunt stated, then the freezing of the LTA worked directly against that. Firstly, it encouraged more pension savers each year to retire at the point where they were coming close to the £1.07m upper limit.

Secondly, it encouraged all defined contribution (DC) pension savers approaching retirement age to move their savings into cash or low return assets to avoid unwelcome heavy tax bills linked to exceeding the LTA. While AA thresholds could be avoided by simply diverting additional savings for retirement into ISAs for example.

However, for NHS workers these sorts of adjustments were not an option because in defined benefit (DB) schemes like the NHS pensions scheme, it's impossible for employees to control in-year pension growth. NHS workers' pension growth is directly linked to the value of pensionable pay.

Increasing pensionable pay, either through extending hours worked or having a pay rise can lead to AA or LTA penalties. While the NHS staff were the most visible manifestation of this conundrum, I'm sure there were many others similarly discouraged from becoming more productive!

Pensions money invested in the future of the UK

Once we have fresh eyes on pensions tax changes - what else can we change for the better? Pensions offer an opportunity for a massive transfer of wealth between the generations. So, it's eminently sensible long term thinking to invest pension money into the businesses of the future!

Too many pension funds, both DB and DC, are invested over-cautiously. This is leading to calls for investment control to be taken away from trustees, perhaps for certain investments to be mandated or for the creation of State-sponsored superfunds.

But before we decide that politicians should determine whether our pension funds should be used to finance the next Garden Bridge or whatever, perhaps the tax system could gently encourage our trustees, advisers or discretionary fund managers to make the right sort of investments.

New innovative companies - the bright young things of tomorrow - need equity finance to take them through the various growth stages of a business. Then, in the years to come, they will be able to deliver the wealth that will pay good pensions.

The freezing of the LTA back in March 2021 worked directly against that virtuous cycle. It encouraged all DC pension savers to move their savings into cash or low return assets in the last few years of work to avoid unwelcome tax bills linked to exceeding the LTA. Yet, clients approaching retirement still have 20 to 30 years of life ahead of them so they should be able to take a long term view to investment. They should not be encouraged to move more money into low growth, ‘safe' assets.

And yes, this might include investment in so-called illiquid investments like Long Term Asset Funds (just green lit by the regulator as a permissible asset for DC pensions) and Long Term Investment for Technology and Science (LIFT) Initiative (a government plan to encourage DC pension schemes to invest in small, innovative, research-intensive UK companies). The Chancellor is set to award up to £250m of tax incentives to those developing the LIFTS initiative in his November Budget.

We may need former workers to ‘un-retire’

This is not just for NHS workers for whom the call was put out early in the pandemic: all sorts of experienced and often senior former employees may find themselves receiving a call asking them to come back to work to lead some project or other. They need to be encouraged to take these roles up, as especially since Brexit the UK has been short of people in all manner of skilled areas.

IFAs who have sold annuities may already have had awkward conversations with clients un-retiring. There is simply no facility right now to say: "hold the annuity payments for a bit, I've got a salary again". It's an HM Revenue & Customs rule that annuities cannot be surrendered.

So those who do un-retire can find themselves in receipt of both pension payments and salary payments at the same time, thereby being propelled into an uncomfortably high tax bracket.

In DB schemes, such as the NHS, it is fiendishly complicated to return to the job and try and rejoin the pension scheme. In the DC world, the money purchase annual allowance (MPAA) disincentivises experienced people from coming out of a period of retirement (in which they have been drawing on their pension) from topping up their pension if they go back to work.

Perhaps their employer will pay them extra salary in lieu of a pension contribution, but that is very inefficient from a National Insurance point of view.

The pension tax system should be encouraging people (or at least not discouraging them) to come out of retirement and go back to work to help out. Perhaps now the LTA has gone, we can dismantle the framework of benefit crystallisation events which sees retirement as only a one-way transition from accumulation to decumulation.

That's just too simplistic for today's labour market and frankly UK plc can no longer afford to have this pool of talent lying idle.

In conclusion, is it not time that we had a long look at the pension tax regime? I'm sure IFAs have dealt with plenty of different retirement-linked conundrums in recent years. They could put this knowledge to work to contribute to an overdue pensions tax review that reveals where the old rules frustrate rather than encourage the behaviours which our post-pandemic, post-Brexit nation now needs.

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