Interactive Investor

Will this pensions’ ‘horror story’ come to pass?

Adding further complexity to the pension system might protect government coffers but risks disincentivising savers. What we need now more than ever is simplicity, argues Rachel Lacey.

15th August 2023 10:23

by Rachel Lacey from interactive investor

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A few weeks ago, a proposed change to pensions legislation made front-page news.

The move was described as a ‘stealth attack’ on UK savers and a ‘horror’ that could affect us all.

The headlines related to a new government consultation on the tax treatment of inherited pensions.

Currently, if somebody dies before they turn 75, they can pass on untouched pensions to their loved ones, tax free. Now the government is consulting on introducing legislation to scrap this perk and force beneficiaries that take this money as income to pay tax on it.

If they took the money as a lump sum, it could still be taken tax free (so long as it was under the £1.07 million limit), however it would fall into the beneficiary’s estate and potentially become subject to inheritance tax further down the line.

Critics quickly pointed out the problems this could create for people who lose a loved one before old age. A husband, for example, whose wife died young, would not be able to take tax-free payments from her pension to help pay childcare bills or replace her lost income, for example.

It could also have a disproportionate effect on women who are widowed at a relatively young age. With less saved for retirement, they are more likely to rely on their husband’s pension.

But the first thing that really struck me about the tabloid headline I saw, wasn’t around whether it was the right thing to do. It was more that I don’t think the vast majority of people have any idea how inherited pensions are taxed in the first place. It was a headline telling people that something they weren’t aware of, could be scrapped.

For me, this is testament to just how fiendishly complicated our pensions system has become.

My second thought was just how regressive a step it was.

Collectively I think everyone who works in the pensions industry breathed a sigh of relief when Jeremy Hunt announced the abolition of the lifetime allowance (LTA) last year.

Yes, it is a tax break that benefits wealthier savers, but, this was the important thing to me, it felt like a positive move towards pension simplification.

As a financial journalist, I was certainly relieved at the prospect of never having to explain the various forms of lifetime allowance protection, or the ‘benefit crystallisation events’ that would trigger a ‘test’ against the LTA.

My work headaches aside, there are already plenty of other mechanisms to limit the amount of tax relief wealthier savers are able to get on pension contributions – like the annual allowance and the annual tapered allowance.

The money purchase annual allowance also exists to stop so-called recycling where savers take money out of their pension and reinvest it for additional tax relief.

But unlike these allowances, the LTA was not based around how much money you have paid into your pension. Instead it punished strong investment performance and had the potential to impact more moderate savers who simply invested well or over a long period of time.

By abolishing the LTA, it felt like an unnecessary layer of complexity and a significant disincentive to invest was being removed.

But now the government is proposing replacing the LTA with not one, but two new lifetime limits - a lump sum allowance of £268,275 (25% of the current lifetime allowance) and a lump sum and death benefit allowance of £1,073,100. Confused? Yes, me too.

The proposals are still at consultation stage and it’s unclear just how they will work in practice. But it gives us a fair indication of the government’s direction of travel when it comes to pensions.

This continual tinkering will tie us all up in in knots and make pensions even more confusing than they currently are. It also makes it really hard for pension savers to plan, with no confidence that the legislation won’t change again at some point down the line.

The more complicated the system, the harder it is to engage with too and the less likely people are to save for retirement.

A few weeks ago, I was chatting to a wealth planner about how we can encourage younger people to save and she made an interesting point. And that’s that while tax relief is crucial in incentivising people to put money away for retirement, it’s the limits that are applied to that tax break, that make pensions and pensions planning so complicated.

And this is where the challenge lies. We need tax relief to encourage saving but the government also needs to cap that relief in some way.

In 2015, the pension freedoms revolutionised how savers can turn their pensions into income. It was a progressive step that has given people more control, flexibility and options.

But as welcome as that change was, the freedom it offers is far from simple.

The ability to take lump sums out of your pension from age 55 garnered many headlines when it was announced and was widely welcomed, but the reality of ‘uncrystallised fund pension lump sums’ is that they can land you with an almighty bill if you aren’t aware of how they are taxed.

Back in 2016, former chancellor George Osborne, did attempt to simplify pension saving and consulted on a range of reforms. Among the proposals were reduced tax relief for higher earners, a flat rate of tax relief or a more radical ‘pension ISA’ where tax breaks are shifted from contributions to withdrawals.

However, the whole consultation was abandoned two weeks before the reforms were expected to be announced in the budget, owing to fears of a wealthy voter backlash.

I would love to be able to say I have a solution – a simpler pension system, that savers understand and feel confident to engage with - but I don’t. What I do know though, is that adding further complexity to the system might protect government coffers, but it won’t do anything to encourage retirement saving. We need to start unravelling some of the many knots we have in the system, not get tangled up in more.

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