OK, not the Lawn Tennis Association, but the Lifetime Allowance.
As a system for controlling tax relief on pensions, the Lifetime Allowance wasn’t all bad at all, other than the not insignificant point about defined benefit savers getting more value than their defined contribution counterparts as highlighted in this frosty exchange from a taxpayer.
The need to scrap the Lifetime Allowance has been brought about by its chipping away and, at each stage, the introduction of one or more set of transitional rules. We now have a web (or should that be Webb?) of rules involving the Lifetime Allowance and its impact on retirement lump sums.
Here’s my top five reasons why the Lifetime Allowance has to be scrapped, in rough order of importance.
1. It’s the Annual Allowance that is now the driver for restricting tax relief on pensions
When the new pension system was introduced in 2006, it was the Lifetime Allowance that discouraged people from saving up too much in a pension on a year by year basis. This was when the Annual Allowance was 1/7th of the Lifetime Allowance (£215,000 compared to £1.5 million) and so if you paid in at the full Annual Allowance level, the Lifetime Allowance would be breached.
Now the Annual Allowance is much lower and is only about 1/30th of the Lifetime Allowance (£40,000 compared to £1.25 million) and so it is much harder to breach the Lifetime Allowance by contributing at the full Annual Allowance level.
2. The system is now too complicated for savers, advisers, pension providers and even the government.
Whilst a Lifetime Allowance of £1.25million isn’t going to affect the majority of the population, pension providers still have to explain it to everyone especially in literature which could be picked up by anyone.
The system is so intertwined that the transitional rules contain drafting errors (I hope they are errors) with could mean that people who were told that their retirement lump sum would be protected may find out that that isn’t true. For those interested, the issue involves people with Enhanced Protection wanting to phase their drawing. So I also conclude that the system is also too complicated for the legal eagles in the civil service who draft the legislation.<
Where we are now reminds me of the game where you have a piece of paper, and the first person draws a head and folds it over to hide it. The second person draws the body and folds that over and so on. You end up with something like this. Yes, successive the paper is the Finance Act, the participants the budget authors since 2006 and when you open up the paper to reveal the whole picture, you see a monster.
The comment by @PhillipWise added to the New Model Adviser story about Steve Webb suggesting the Lifetime Allowance should be scrapped sums this up nicely: Alternative Title “Webb loses Fixed Protection by failing to Opt Out”.
3. There is huge arbitrage between a final salary pension saver and a SIPP pension saver.
A known issue since the introduction of the Lifetime Allowance in 2006 which has got worse as annuity rates have declined, this issue was dubbed Pensions Apartheid by The Daily Telegraph in 2012 who at that time said the difference was a maximum annual pension of £62,500 in a final salary scheme compared to a £35,000 annual pension in a drawdown plan.
This silly situation leads to some opportunities for arbitrage which might not ordinarily suit the individual: accepting a lower initial pension for higher pension increases and/or dependant’s income and/or retirement lump sum; using scheme pension mechanism for a money purchase scheme.
Surely if there is going to be any imbalance in worth between a final salary pension income and a money purchase pension pot, the system should favour the less fortunate money purchase pensioners. This group accepts investment and longevity risk and yet the rules penalise them if their investments do well: which brings me on to the next point.
4. Savvy investors are penalised
The Lifetime Allowance brings about an additional tax on pension savers who pick the right investments and I would hazard a guess that over-performing investments may be more the likely cause for breaching the Lifetime Allowance than just being greedy and paying in too much. Generally investment returns are not controllable (not positive investment returns anyway), so the better system is to restrict pension contributions rather than restrict the accumulated value of them.
It seems socially acceptable to tax successful investors, yet there is no need to tax a lottery player who wins big, even though that is down to pure chance rather than any particular skill – can’t we celebrate successful investors too?
5. For all the best intentions, it is effectively a retrospective tax and seen to be changing the rules in the middle of the game.
Pension is deferred pay and with that an understanding that there is deferred tax with pension income taxed at the prevailing rate of income tax when it is drawn.
Given this lock in, it isn’t fair that people saving up on one set of rules can get penalised retrospectively by a change in policy. Whilst this retrospective taxation is minimised by introducing transitional rules (which brings about the pension monster referred to above), the rules generally are not sufficient.
For example, whilst the introduction of Fixed Protection 2014 gives a pension saver an underpinned Lifetime Allowance of £1.5 million provided they have any further pension input, that person may have built up funds expecting that its growth will not breach a Lifetime Allowance growing from a base of £1.5 million by 20% to say £1.8 million. When the Lifetime Allowance instead drops, this changes the equation as it may now be highly unlikely that the Lifetime Allowance will grow from £1.25 million to £1.8 million in the same time period.
In my next post, I’ll look at some of retirement decisions that are driven by tax when, in the absence of the Lifetime Allowance, a different decision more aligned with the individual’s circumstances should be taken.