The lifetime allowance’s popularity, rather like its value, has been dropping for years. The annual allowance has arguably had less bad press so far, but with the introduction of the universally hated tapered annual allowance following closely behind the money purchase annual allowance (MPAA) and last year’s transitional rules, that’s probably set to change.
The lifetime allowance’s popularity, rather like its value, has been dropping for years. The annual allowance has arguably had less bad press so far, but with the introduction of the universally hated tapered annual allowance following closely behind the money purchase annual allowance (MPAA) and last year’s transitional rules, that’s probably set to change.
Pensions carry a number of tax advantages, and it’s generally accepted that it wouldn’t be sustainable for those to be unlimited. However, it’s less clear whether the annual and lifetime allowances are the best way to achieve this, particularly given the number of changes to both in recent years.
The allowances’ origins
A question heard many times in relation to the allowances is, if we’re limiting what goes in, why do we need to limit what comes out? In answer to the question, this problem has developed as the two allowances have evolved over time.
The annual allowance started off at £215,000 – more than five times its current level. But this amount was based on flexibility, rather than on generosity. This allowance enabled investors to make large single contributions in years when their income was exceptionally high.
It also helped those who left pension planning until later in life to build a substantial fund in a relatively short time. However, the aim was never to allow high earners to build enormous tax-relieved funds by maximising this allowance every year of their working lives, and this is why the lifetime allowance arrived at the same time.
To look at it the other way around; what if the government had only set the lifetime allowance, and hundreds or thousands of high earners decided to fully fund their pensions in any given year? This would most likely cause huge problems with the government’s income tax receipts, not least because the effect would be unpredictable from one year to the next.
Introducing the annual allowance at the same time helped to smooth the overall amount of tax relief over a number of years.
In 2006, it made sense to have both allowances. They worked together to give pension investors flexibility when it was needed, but also to give an overall limit to the tax advantages available and deliver tax relief in a more controlled way.
But what about now?
Both allowances have dropped significantly – but not proportionally – since 2012. If only one had gone down, the above arguments for having both would probably still make sense.
We would be able to see there was either a need to lower the overall level of tax-advantaged benefits, or to spread tax relief over a greater number of years. With both allowances dropping, the need for both becomes increasingly tenuous
Just before the first reductions, the annual allowance and lifetime allowance were £255,000 and £1.8m, respectively. With reasonably modest growth of 3 per cent (and admittedly rather crude calculations), an investor could reach the lifetime allowance with tax relievable contributions within about seven years.
Contrast that with last tax year, when the annual allowance was £40,000 and the lifetime allowance was £1.25m. Using the same calculations, an investor using their full annual allowance each year would now need 23 years to reach the lifetime allowance.
Tapering rules
A high earner subject to the tapering rules could have an annual allowance as low as £10,000 from this tax year onwards. Such an individual would need 47 years to reach a lifetime allowance of £1m.
With the recent pace of changes to the rules, it seems unlikely that the lifetime allowance will exist in its current form in five years’ time – let alone in five decades. Therefore the recent drops in the lifetime allowance primarily affect those who are already nearing the end of their retirement savings journey and have made most, if not all, of their contributions.
These are the investors for whom the lifetime allowance feels little more than an unfair, last-minute shift of the goalposts or a punishment for good investment performance.
At the same time, we are constantly being told that people are not saving enough for their retirement. Every week there seems to be a new statistic about the number of people approaching retirement age with little-to-no pension provision, or the proportion of younger people who feel they’ll never be able to retire. The government says that it wants to encourage investors to save more towards their retirement.
However, many would argue that the greatly reduced annual allowance, alongside its various spin-off rules and transitional arrangements, is putting people off engaging with pension planning.
There have been comments suggesting the rules don’t match the message of saving more, as the annual allowance now prevents investors from saving as much as they need to.
No limitations
Of course, neither the annual or lifetime allowance actually prevents anything. While their purpose is to limit the pension tax advantages enjoyed by each individual, they are not, in themselves, limitations.
There is no limit on how much a person can contribute to their pensions each year, nor on the amount of pension benefits someone can receive during their lifetime.
Despite this, a lot of time and effort goes into staying within the allowances. Again, this made more sense a few years ago: both allowances were high enough that the majority of investors couldn’t have exceeded them, even if they’d like to.
Savers became used to thinking of the allowances as maximums, and this view stuck as the allowances began to drop. However, the allowances are now low enough that this view could interfere with investors’ retirement plans.
Most investors who have lowered their contributions or fund value target will have made alternative arrangements for their retirement, but it’s worth considering the circumstances in which exceeding the allowances could still be beneficial.
For example, consider an investor who is already close to the lifetime allowance, and whose company offers employer contributions, but no alternative benefit.
While the contributions will take the fund value above the lifetime allowance, the investor will still be in a better position than if they had refused the contributions altogether.
Annual allowance
With the annual allowance, it’s all too easy to forget about tax relief when considering the annual allowance charge. Entitlement to tax relief is based on an individual’s relevant UK earnings, regardless of the annual allowance.
The charge takes back tax relief given to contributions above the annual allowance. In effect, contributions above this are paid net of income tax. In other words, they’re in the same position as if they’d been placed into practically any other savings vehicle.
Of course, investors who have used their annual allowance have other tax-efficient options, but pensions still have a number of features that could make them worthy of consideration for their extra savings:
• Investments grow free of tax and exempt from capital gains tax,
• A wider range of investment options than some other savings vehicles, such as Isas,
• Investors cannot normally access benefits until age 55, so the savings are ring-fenced from being spent too soon,
• The funds are normally held outside the investor’s estate,
• There are a number of tax-efficient options for beneficiaries on death.
Retirement needs
Pensions are long-term savings vehicles, and it can be hugely frustrating that the legislation governing them keeps changing so significantly.
After all, hidden somewhere behind this whirlwind of changing rules are real investors, with real needs for their retirements. These needs may change as time passes, but are still likely to be more stable than tax rules.
The nature of the annual and lifetime allowances has undoubtedly shifted since their introduction 10 years ago, and it’s questionable how much longer either will last in its current form.
For the moment, all everyone can do is consider them as features of a savings product, and try not to let them interfere with an investor’s long-term goals.
Jessica List is pensions technical analyst at Suffolk Life
