'Getting serious about pensions'

Money Talk by Tom McPhail
Hargreaves Lansdown

Image caption,
The Budget included some key issues for pensioners

In the Budget, Chancellor George Osborne said that he intends to reverse the tax relief restriction imposed on high earners by the last government.

This sends a positive message to all that this government is serious about getting us all saving for retirement.

His announcement has been met with widespread approval from across the pensions industry. Unfortunately, there will still be complications and possible tax charges for some.

The government proposes to restore full tax relief for those earning over £150,000. This means investors will be able to enjoy tax relief of up to 50%. In effect, it will only cost them £500 to get £1,000 in their pension.

This is good news not just for the higher earners, but also for anyone who may have been worried about the government making further reductions to pension tax relief.


The trade-off, though, is that while the tax relief rate is going back up, the government intends to make a very significant reduction to the amount that anyone can pay into their pension every year.

The proposed limit is likely to be somewhere between £30,000 and £45,000 a year. This is very substantially less than the current annual allowance of £255,000.

For someone in a money purchase pension, such as a Stakeholder or a Sipp, this is reasonably straightforward.

Provided the total value of the contributions paid by you and your employer do not exceed the new lower limit, you will be able to continue to enjoy tax relief on the contributions. If the value of your combined contributions exceeds the limit, then you will be hit for a tax charge.

It is worth noting that a £25,000-a-year pension contribution over 35 years will produce a pension fund of about £1.6m, assuming 6% net growth. For most people, therefore, the lower limit should still permit good levels of pension funding.

For final salary scheme members, though, this reversion to the old system but with a much lower annual allowance could cause complications and result in a possible tax charge.

This is because of a slightly complex calculation that HM Revenue and Customs (HMRC) uses to establish the value of one year's increase in an employee's final salary pension.

HMRC take the value of pension rights at the end of the year and deduct from this value the pension rights from the start of the year. They then multiply this resulting increase in the employee's pension rights by 10 to give a capital value for increase in the annual income.

Here's an example:

  • Employee aged 40 with 10 years' service in a 60ths pension scheme
  • Salary at start of year is £35,000 and salary at the end of the year is £36,000
  • Pension rights at start of year £35,000 x 10/60 = £5,833
  • Pension rights at end of year £36,000 x 11/60 = £6,600
  • So the increase = £767 (£6,600 - £5,833)

In this case, the value of increase for annual allowance purposes is £7,670.

This is well within the proposed reduced annual limit of between £30,000 and £45,000, so there are no problems. But look what happens to someone who gets a significant pay rise, perhaps as a result of a promotion:

  • Employee with 25 years' service in a 60ths pension scheme
  • Salary at start of year is £50,000 and salary at end of year is £60,000
  • Pension rights at start of year £50,000 x 25/60 = £20,833
  • Pension rights at end of year £60,000 x 26/60 = £26,000
  • So the increase = £5,167
  • Value of increase for personal allowance purposes = £51,670
  • Possible tax charge at 40% = £2,668 (£51,670 - £45,000 x 40%).

The government plans to consult on these changes. No doubt one of the questions will be, how we can come up with a valuation system that does not unduly penalise pension scheme members who have built up substantial pension rights and then get a big pay rise.


As is so often the case with pensions, the devil will be in the detail.

There are ways to offset this potential problem - for example, by operating a sliding scale of multiples which would produce lower capital values for employees with longer periods of past service.

HMRC have just published legislation which would deliver the changes in time for the start of the next tax year.

In the meantime, we just need to work through the precise details of how it will work before next April.

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