Reviving the lifetime allowance hurts those aspiring to good pensions

A bung for the rich and just another example of the Tories pandering to older, wealthier voters.

This was the gist of the reaction in some quarters to the Budget announcement that the pension lifetime allowance would be abolished.

Six weeks on, the dust has settled on Jeremy Hunt’s announcement, but savers appear to be cautious, with an AJ Bell survey saying three-quarters expect this pensions tax trap to return.

That’s hardly surprising, because almost as soon as the Chancellor had declared he was scrapping the lifetime allowance, Labour claimed they would bring it back if elected.

Putting the cap back on: Shadow Chancellor Rachel Reeves has said the Labour party would bring back the lifetime allowance

Shadow Chancellor Rachel Reeves said Labour would reinstate a cap on the amount that can be saved in a pension pot without facing tax penalties, labelling it a ‘untargeted tax cut for the richest 1 per cent’.

She didn’t say whether it was the same £1.07million cap that her party would bring back and nor did her colleague Angela Rayner in her later comments. But Labour also didn’t move to confirm any revived cap would be higher or fairer than the outgoing one.

A thread common in other criticism was that removing the lifetime allowance increases intergenerational unfairness by benefiting older savers.

But is this narrative entirely accurate?

Is it really the case that we don’t want people to aspire to an annual pension income any greater than £43,000? 

On the surface you might think so. After all a £1.07million pension seems like an unfeasibly large amount for a normal person to save.

But if you flip that figure around and look at the pension income such a pot will buy, you realise why many long-standing critics (me included) of the lifetime allowance have labelled it a tax on the aspirations of younger savers.

The £1.07million lifetime allowance would have bought income of £42,800 a year from a pot drawn on at a standard rate of 4 per cent a year.

That may be big compared to most but it’s hardly fat cat territory.

Is it really the case that we don’t want people to aspire to an annual pension income any greater than £43,000?

To put that figure into context, the benchmark PLSA Retirement Living Standards report suggests that for a comfortable retirement an individual needs £37,300 annual income.

Considered in another way, about £43,000 per year is the kind of pension income many of the current retiring generation of higher-earning workers would expect to get from their final salary and other defined benefit schemes.

Schemes differ, but someone who has accrued a pension at a rate of 1/60th of their final salary over their 40-year career, could retire from a job paying £65,000 with a £43,333 pension.

Someone who has accrued a final salary pension over their 40-year career, could retire from a job paying £65,000 with a £43,333 income

It’s not high-flying City types doing this. Among the people managing to achieve such a retirement income are senior teachers, engineers, train drivers, council officers, and managers across different industries.

Of course, many will have had latter years of their pension schemes downgraded – perhaps from final salary to career average – or lost the ability to accrue more towards the end of their working life.

But at least they have spent most of their careers racking up these top-notch defined benefit pensions, where their employer takes on the responsibility for their promised retirement income and that pledge is heavily protected.

The generation in their 20s, 30s and 40s working in the private sector now are unlikely to be getting any such thing.

Instead, they get defined contribution pensions the worker and their employer pay money into, with the sum invested to deliver a pension pot that the individual is then responsible for turning into a retirement income.

> Pensions explained: What you need to know about how they work 

This leaves the younger generation of pension savers far more exposed to the whims of the market: long-term stock market gains, volatility, and uncertain income are all factors they must somehow consider. Many consider themselves ill-equipped to do that.

On top of that, until the Budget announcement they also faced a pension lifetime allowance that wasn’t based just on what they have paid in but also any investment growth.

And to compound the problem, instead of rising with inflation, wages, or average market performance, as you might expect such a cap to do, the lifetime allowance had been repeatedly hacked back.

It was introduced at £1,500,000 in 2006 and by the time Labour left power it had been increased to £1,800,000.

But then successive Conservative Chancellors got hold of it and the lifetime allowance was repeatedly cut, falling all the way down to a £1million low from 2016 to 2018.

By the time it was axed five years later, it had managed to rise by the princely sum of £73,100 to £1,073,100.

If the lifetime allowance had risen in line with RPI inflation from its introduction at £1,500,000, it would now stand at £2,670,000.

Clearly, the lifetime allowance is not only a badly designed cap – as it includes investment growth as well as what is paid in – but also one you can’t trust.

Put £410 into a pension each month, with an average annual rate of return of 7% and after 40 years you would have a £1,076,000 pot 

Removing it might look like a bung for older, richer savers but it’s a greater help to younger workers aspiring to a high salary and decent retirement income, who do what they are told and start saving early.

Someone who saved £410 into a pension each month – from their own and employer contributions plus tax relief – with an average annual rate of return of 7 per cent after 40 years would have a £1,076,000 pot.

That’s enough to hit the lifetime allowance that just got scrapped.

I don’t know why you would want to bring such a flawed system back. Especially not when you already have an annual allowance in place to stop the highest earners making out like bandits on pension tax relief.

Labour should at least try to bring some clarity to the situation. 

Would they bring the lifetime allowance back at the £1.07million it was scrapped at, the much higher £1.8million they left office with it at, or at a different figure, and would it be indexed for inflation or investment growth?

I put that question to Rachel Reeves’s office yesterday for This is Money readers, but understandably she didn’t want to be drawn on such a hot potato issue. 

Labour owes it to pension savers to come up with an answer soon though.

What would it take to hit a £1.07m pension pot? 

A £1.07million pension pot is much bigger than most savers will reach but it is not as unattainable as many people think.

If someone saved £410 per month into a pension for 40 years and achieved an average annual rate of return of 7 per cent, they would hit £1,076,000.

Saving £410 is a tall order, but it is important to note that not all of that money comes from the individual. 

Workers get basic rate tax relief on pension contributions that gives a 25 per cent boost on what they put in and employers contribute to – with matching employee contributions commonplace.

A typical £410 per month contribution could break down like this:

Worker: pays in £185

Employer: pays in £185 

Basic rate pension tax relief:  £46.25

Total: £416.25

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