OpinionNov 16 2021

Pension contribution allowances should get reviewed again

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Pension contribution allowances should get reviewed again
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There are significant issues surrounding both the annual and lifetime allowances, particularly with regard to how these are applied to different types of pension schemes and the challenges this brings to the planning process.

It is harder for those without advisers to navigate these issues and get the best outcome. 

Some history

The lifetime allowance and the annual allowance came into force on 'A-day' (April 6 2006), but that wasn’t the first time that there were limits on the amount that you could save into a pension.

Prior to this, there was a limit on what you could pay in annually on personal schemes and what you could accrue in your lifetime in occupational pension schemes. Many couldn’t accrue benefits in both types of scheme at the same time.

There were exceptions though, such as doctors and dentists, who could have both types of pension at the same time. 

As part of the pensions simplification introduced on A-day, the restrictions on who could save into different schemes were lifted and it was decided eventually that limits were needed that worked for all types of scheme.

This was supposed to be simpler, yet with hindsight we know it didn’t really work out. It is understood that ideally only one test would be required, but that in the end this wasn’t thought to be sufficient, given the size of the allowances at that time.

The annual allowance was planned to reach £255,000 in the first five years and the lifetime allowance £1.8m, with increases being set again by Treasury order after that.

As we know, they never got above these figures and began to drop, adding complexity and bringing more people into the realm of charges. 

Lifetime allowance

The lifetime allowance is designed to restrict overall savings into a pension, with the charge recouping some of the tax relief given if you exceed it. However, the tests applied for defined benefit and defined contribution schemes are significantly different.

The multiples used for the DB test haven’t been amended or reviewed in the past 15 years, meaning that there is an increasing discrepancy in the benefits that can be provided by the different types of pension scheme.

You can easily build much greater pension income within a DB pension scheme than you can in a DC scheme.

It is my belief that the lifetime allowance is much more aligned with DB schemes and penalises those in DC pension schemes, especially those who gain significant growth on their investments.

It does appear that it is designed to unfairly tax those that have the least control over their overall benefits and those willing to take an increased risk for the potential of a larger pot in retirement. 

This all just leads us to the fact that the lifetime allowance, while requiring review, is best placed to test DB schemes. 

Annual allowance

The annual allowance, money purchase annual allowance, and tapered annual allowance are all there to restrict the amount saved into a pension scheme in any one year.

In some cases, it is possible to use unused allowance from the previous three years to help when there are years in which contributions or deemed contributions are high.

Carry forward was invented to help smooth DB accrual because it isn’t easy to restrict this in any one year, unlike contributions to DC pension schemes. 

Again, the tests for DB schemes and DC schemes are so significantly different that they are not testing like for like.

DB schemes’ deemed contributions bear no resemblance to the amount actually used to secure the accrual each year – this is understandable because in many cases it isn’t disclosed how much an employer is paying into a pension scheme each year.

The multiple has been reviewed since the introduction of this test in 2006, increasing from 10 times the benefit to 16 times, but now factoring in inflation.

This means that it is very difficult for anyone in a DB scheme to make a good estimate of their annual allowance usage before the scheme provides the data.

On the other hand, it is easier to estimate with a DC scheme as it is what you put in, including employer contributions and any tax relief claimed by the scheme.

As you can see, it appears when looking at the annual allowance that it is more suited to testing DC pension schemes than DB accrual. 

The future

The future of these allowances is uncertain, but it seems unlikely that they could be changed significantly in the short term, due to the way in which individuals often have a mix of different types of pensions. 

It could be that we need to consider if the tests should be split, but there would then be a need to be able to deal with the multiple types of pension schemes available and actively in force at this time. 

What is clear, however, is that the multiples used to test benefits in DB pension schemes are ripe for a review, which in theory would be an easy way to level up or down the benefits members can accrue both annually and in their lifetime.

It would not resolve the wider issues in the pension world with regard to the lack of ability to plan, and with regard to those who are penalised by good investment growth in DC schemes or significant pay rises in DB schemes. 

With the lifetime allowance currently frozen, this will clearly mean that more people will be affected by the lifetime allowance charges in the coming years and that it will become ever more restrictive because it isn’t keeping pace with inflation.

This all leads to people looking elsewhere to save for their retirement because, yet again, we have a complex system that favours some investors over others.

Claire Trott is divisional director – retirement and holistic planning at St James's Place