Lifetime pension allowance threat to future income

It has produced data based on a joint life annuity with inflation escalation, which show the current £1.25m cap on tax-free savings would now generate an income of £32,000. In 25 years if the lifetime allowance were to remain unchanged, this would fall to £19,810 in today’s money.

Both cases assume an annuity rate of 2.6 per cent, payout of 50 per cent on the first death and 3 per cent inflation escalation. For the purposes of the income erosion inflation is assumed at the Bank of England’s long-term target of 2 per cent.

Savers who go beyond the annual limit can continue to accrue savings into their pension, but are hit with a ‘lifetime allowance charge’ bill on the amount above the cap when they seek to access their funds.

Those taking a lump sum, which more are expected to do from April when pension freedoms come into force, would be hit with a tax charge of 55 per cent on the excess savings. Those taking their fund as regular income would face a lower rate of 25 per cent.

These charges are taken from the fund before it is paid out and marginal rate taxes that will apply from April would be taken from the remaining amount when it is paid.

Having risen from £1.5m to £1.8m between 2006/2007 and 2010/2011, deficit cutting measures have seen the lifetime allowance reduced substantially during this parliament to now £1.25m. The annual allowance has also been dropped and stands at £40,000.

Last year, the Liberal Democrats came under fire for proposing to tighten the cap on pension tax relief by further limiting the lifetime allowance, as a measure to help raise further funds to cut the deficit and pump funds into the health service.

The reduction in lifetime allowance in this financial year from £1.5m to £1.25m was estimated to affect around 360,000 individuals who could have pension wealth between the new and the old allowances in future years.

Some 30,000 of those people are expected to have pension assets that are worth between £1.25m and £1.5m in 2014-15. The government has also estimated up to 140,000 individuals are expected to be affected by the reduction in annual allowance to £40,000.

Zurich added that people in defined benefit schemes are slightly sheltered from the possible charges, because for the purposes of the lifetime cap the estimated funds is 20 times the annual payout.

This presents a very significant undervaluation in today’s market and, given the fact that most defined benefit pensions have spouses pensions and index linking, it would be more accurate if the fund was estimated at double this amount, the firm said.

As a result, for defined benefit pensions individuals only go over the cap when they have a private pension income of £62,500, which implies a typical final salary of £93,750.

Zurich said in a statement: “We believe people who are making decisions about saving over two or three decades should be given more certainty than this about how their pensions will be taxed, and think it would be fairer for the allowance to reflect the actual amount that people actually invest into a pension as opposed to its overall value.”

Some have suggested pensions taxes could be simplified by undertaking a more radical overhaul of pension taxes and relief, with the Centre for Policy Studies proposing the lifetime allowance is scrapped and tax relief simplified to a 33.3 per cent rate irrespective of earnings level.

ruth.gillbe@ft.com

Additional reporting by Ashley Wassall