Countdown to the Spending Review: raiding your pension

The day of the spending review looms. In the latest of a daily series in the run-up to 20 October we brief you on the outlook for pensions.

With only days to go before the big cuts in government spending are announced, what more can we expect on pensions?

Little relief from tax

The cost to the Treasury in lost revenue from tax relief on pensions is at least £19.7 billion and has more than doubled in the past 10 years. Most of this relief goes to higher rate taxpayers and those who are relatively well off. 

A reduction in the annual amount which can be saved tax free in a pension scheme from £255,000 to £50,000 has already been announced and there is also a reduction in the ‘lifetime limit’ the maximum pension pot from £1.8 million to £1.5 million. This will affect some 100,000 better off pension savers according to the Treasury who currently contribute more than £50,000 into their pension schemes each year.

The Treasury has also confirmed that there will be no further reductions in tax relief in the spending review on 20th October so it is unlikely that tax relief will be reduced to the basic rate of 20% for all savers – as many had expected. There may be other reforms however.

The changes will save an estimated £4 billion a year. The reduced annual allowance takes effect from April 2011 and the reduction in the lifetime allowance from April 2012. The aim is to simplify pension tax relief replacing the complicated proposals made by the previous Labour government. The Treasury has said that the £50,000 annual allowance will not be indexed to reflect inflation until 2016 at the earliest. Freezing it means its value will be cut to £44,000 in real terms by 2015 which will produce further, as yet unquantified, savings.

Inflation threat

The biggest cutback of all has already been announced – the switch linking pensions to the Consumer Price Index, instead of the generally higher retail prices index (RPI). This is estimated to save £5 billion a year by 2016. Next April is the final year when the basic state pension will be linked to RPI rather than CPI and pensioners will see their income rise by the 4.6% September increase in the RPI for the last time. The CPI figure for September is 3.1%. With the gap between the two indices current standing at 1.5% this will have a huge effect on pensioners’ income – and pension providers’ costs.   

In addition, all private pensions will in future be linked to CPI unless the trust deed specifically mentions RPI. Employee benefit consultants, Towers Watson, calculates that if the gap between RPI and CPI remains as it is, pensioners currently receiving £10,000 will receive £11,400 rather than £12,200 in 2016. This is a massive cut which will become progressively worse.

What else can we expect?

The big question now is whether the chancellor will introduce further reforms when he announces his spending review on 20 October. Other changes already announced include an increase in the factor used to value the benefits in a final salary linked pension scheme from 10 to 16, which means that some pension scheme members may face tax charges. Higher earners and those who get significant salary increases are most likely to be affected. However, there will also be a three-year smoothing mechanism to allow staff to 'average out' any significant pay rises.

Pension consultants were also expecting closure of the loophole which originally allowed tax-free pension contributions of 100% of earnings in the year before retirement, later reduced to £130,000, (provided the overall lifetime cap was not exceeded) – often totally wiping out the individual’s income tax liability. But with the Treasury confirming that there will be no more changes to pension tax relief this now looks unlikely.

A move towards a ‘career average’ basis for calculating pensions rather than the current ‘final salary’ method is on the cards too – not least of all because Hutton recommended such a move for public sector pensions to reduce the cost to the taxpayer. He called final salary schemes ‘inherently unfair’ and the government is likely to encourage a switch towards career average rather than final salary schemes. 

This would prevent high flyers from being given a massive pay increase in the year of their retirement in order to boost their pension for the rest of their life – often to the detriment of lower earners who are still contributing to the scheme. Costs will be reduced too by the Hutton proposals that public sector workers, particularly those on higher earnings, contribute more towards the cost of their pensions.

Other Citywire Spending Review guides:
Countdown to the Spending Review: a fierce battle over defence cuts
Countdown to the Spending Review: where the benefit cuts will bite
Countdown to the Spending Review: education by numbers
Countdown to the Spending Review: taking a sledgehammer to housing