Osborne’s Last Pension Change
In previous issues of Labour Affairs we have been critical of changes made by George Osborne to the UK’s pension system. A good pension system should aim to provide retirees with a net (after tax) income replacement rate of some 60-70% of pre-retirement net income for those on average incomes. We argued that such income replacement rates are not met with the voluntary and low contribution rates required under Osborne’s legislation.
Furthermore, pension pots should be used to buy a guaranteed income in retirement. Osborne removed this requirement because of widespread dissatisfaction with the poor annuity markets. A much better way to have addressed the problem would have been through the promotion of Collective Defined Contribution (CDC) funds. The coalition government did introduce enabling legislation so that CDCs are now legal in the UK. The Liberal Democrat pension spokesman, Steve Webb, attempted to raise the profile of CDCs with much support from the trade union movement but Osborne had little to say about them.
In one of his final moves on pensions Osborne reduced the size of a pension pot that could be built up from untaxed income down from £1.25 million to £1.0 million. Should one support such a move? On balance I would say yes. One of the results of this change will be that higher earners will have smaller pensions in the future. Yet the change has a progressive aspect that should be supported.
Pension pots are built up from income that is not taxed. Any income over ~£43,000 is taxed at 40%. If someone is earning an income of £75,000 then £32,000 of that income would be taxed at 40%. But the earner can instead put £32,000 into their pension pot and only pay tax on the remaining £40,000. If someone did this for 40 years they would have a pot of at least £1.4 million plus whatever the pot has grown by which would be well above the £1.0 million allowed by Osborne’s new rule.
Osborne’s change thus reduces the benefit which high earners can get out of the pension rules and this is to be welcomed. Effectively high earners will now be paying more tax. That seems progressive. This approach, which means that the income replacement rates of those on higher incomes decline as income rises, is typical throughout the world.
However there is a side of this change that has not yet perhaps been understood by people and is worth pointing out.
Workers on defined benefit schemes do not have pension pots. However an implied pension pot is calculated by HMRC by multiplying the value of their annual pension by 20. Thus someone on an annual defined benefit pension of £50,000 would have an implied pension pot of £1.0 million. Any pension over the £50,000 limit would be taxed at 55% rather than 40%.
It seems likely that many high earners in the public sector on defined benefit pension schemes will be affected by this change. However it’s a progressive change in that it limits the benefits to be gained from the tax system as income increases.
European systems typically employ such restrictions. They aim for replacement rates of 60-70% but only for those earning the average wage. As your income increases your replacement rate will decline. Those on lower than average incomes will achieve higher replacement rates.
For the curious here are the net pension replacement rates published by the OECD for public and mandatory pension schemes in Europe sorted by replacement rate for average earnings.
|Net pension replacement rates from public and mandatory private schemes against fraction of average earnings|
|0.5 *av. earnings||1 * av. earnings||1.5 * av. earnings|