As weary politicians lick their wounds during summer recess, advisers and the wider financial services industry are braced for another turn around the ‘pensions tax raid’ rumour carousel in the build up to the Autumn Budget.
With President Trump’s trade war likely to push down UK growth expectations and interest rates remaining persistently high, Rachel Reeves faces an even more perilous fiscal situation than she did in October 2024 – a situation that will likely demand the chancellor finds tens of billions of pounds in extra tax revenues.
Having already rinsed employers for £25bn through her National Insurance (NI) raid last year and ministers continuing to insist the pay packs of ‘working people’ will be protected – meaning no rise in income tax, NI or VAT rates – avenues to raise material sums of cash for the Exchequer without fundamentally undermining Labour’s manifesto commitments are thin on the ground.
“But look over there!”, a think-tank will inevitably soon say. “Pensions tax relief costs over £50bn every year and most of it goes to higher earners. That’s low hanging fruit! Surely a flat rate of tax relief would be fairer and could raise billions in revenue for the Treasury in the process? And while you’re at it, who really needs £268,275 in tax-free cash? Let’s slash that too! Job done!”
Any move to restrict tax-free cash entitlements would save little money in the short-term and cause a similar firestorm
As ever with pensions, it’s not as easy as that. Let’s start with the overall net ‘cost’ of pensions tax relief, estimated by HMRC at £52.5bn in 2023/24. About a third of the gross annual tax relief cost relates to NI relief on employer contributions – presumably a no-go area on the back of last year’s increase in employer NI costs.
In fact, only £4.4bn of the cost of tax relief relates to ‘relief at source’ schemes, with £6bn going to employees in ‘net pay’ arrangements, including defined benefit (DB) schemes, and a further £7.2bn linked to pensions salary sacrifice.
Any proposed reform of pensions tax relief would therefore need to include net pay and relief at source schemes, comprising defined contribution (DC) and DB schemes, both to raise substantial revenue and because anything else would be grossly unfair. And this is where things get really problematic.
Let’s imagine, for arguments sake, the government wanted to introduce a 30% flat rate of pensions tax relief across the board. For anyone in a DB scheme earning more than £50,270 (the higher-rate income tax threshold), a tax charge would need to be applied to reduce their automatic tax relief from 40% to 30%.
If a higher-rate taxpayer had paid a £10,000 contribution to a net pay scheme in the tax year, they would presumably need to pay a £1,000 tax charge to reduce their tax relief to the required 30%.
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Given public sector workers were up in arms over the impact of the lifetime allowance and annual allowance on their pensions and there have been doctor’s strikes over pay in recent weeks, it’s hard to imagine hiking tax bills for all those saving in a pension and earning over £50,270 would go down particularly well.
Pensions salary sacrifice, a hugely valuable benefit enjoyed by millions of people, could also be on the chopping block in this scenario.
Any move to restrict tax-free cash entitlements would save little money in the short-term and cause a similar firestorm across members of both public and private sector pension schemes. And a complex protection regime would presumably be necessary for those who have saved diligently based on the current tax-free cash limits.
There is also the issue of intergenerational fairness to consider – particularly if the government were to opt for a more dramatic reduction in tax relief to, say, 20%. Younger workers who already, on average, benefit from less generous workplace pensions than their parents and grandparents would now also miss out on the potential benefit of higher-rate pension tax relief and tax-free cash as they progress through their careers.
The constant rumour and speculation about pension tax relief and tax-free cash is fundamentally destabilising
In addition, any move that potentially deters people from contributing to pensions would also run counter to wider efforts to boost long-term investing, including in UK companies.
The constant rumour and speculation about pension tax relief and tax-free cash is fundamentally destabilising for long-term savers. Given the government has committed to stability and has shown a desire to deliver better retirement outcomes, providing at least some certainty around the incentives that exist to save for retirement doesn’t seem a lot to ask. This could be delivered through a ‘Pensions Tax Lock’ pledge – a commitment not to touch tax relief or tax-free cash, at least for the rest of this Parliament.
It is within the chancellor’s gift to deliver this ahead of the Budget. If the reaction of public sector workers means it is off the table anyway, why not seize the opportunity to show you’re on the side of hard-working savers without spending a penny to do so?
Tom Selby is director of public policy at AJ Bell
