The long read | The autumn Budget and Defined Contribution pensions – Rumours and reality checks
28 October 2024
Speculation about how Rachel Reeves might raise money is rife, and pensions figure prominently in the rumour mill. Andrew Overend, Partner and Head of Investment Consultancy, provides a reality check on the potential impact of the autumn Budget on retirement savings in Defined Contribution (DC) arrangements.
To get some idea of how the autumn Budget might affect retirement savings, let’s start by looking at the DC savings environment.
To date, most retirees have been able to rely on at least some Defined Benefit (DB) income, but the situation is changing. Over the next few years, we’ll see more and more individuals planning to retire with only DC savings.
Whether they will be able to retire though is open to question. In many cases, the size of their DC pot is likely to fall well short of the amount required to provide the retirement lifestyle they’re anticipating.
It’s clear to me that awareness of the size of DC savings required to provide a comfortable retirement is poor. Most people simply don’t know how much money is required.
An annual income of £43,000 for a single person and £59,000 for a couple are needed to live comfortably, according to the Pensions and Lifetime Savings Association’s (PLSA) retirement living standards.
For most people, the State Pension – the full amount currently standing at £11,500 pa – will provide a good foundation. But that leaves DC savings pots with some heavy lifting if they’re to make up the additional amount recommended by the PLSA. Based on current annuity rates, a 65-year-old retiree will need a DC pot of approximately £600,000.
When assessing the Government’s pension policy, it’s easy to assume that changes will only affect the wealthy. The reality though is that a sizeable pension pot, which may at first glance seem to be the preserve of the wealthy, is actually what ‘normal’ people need.
As a civilised nation, shouldn’t we strive to provide a comfortable retirement for as many individuals as possible?
To achieve this, the Government should foster an environment which encourages as many as possible to accumulate a pot of at least £600,000.
Any government message (or budget measure) that creates the impression that a DC pot in excess of £500,000 is the preserve of the wealthy is counterproductive. The Government’s primary pension objective should be to paint a realistic picture which will push people to save more.
The gap between private and public sector pensions
The PLSA’s research also reveals that pension contributions of 8% (the minimum auto-enrolment level) over the working lifetime of an average earner will result in a DC pot of around £110,000 and an estimated retirement income of £18,400 per annum, including the State Pension.
By comparison, a nurse starting work today at age 22 can expect to receive an NHS pension of about £30,000 pa (in today’s terms) from age 68, with the State Pension on top.
The difference between public sector DB and most private sector DC pensions is staggering and widely underappreciated.
Most private sector employees are unlikely to be saving anywhere near enough to provide the level of retirement income they’re anticipating. At some point over the coming years, I expect awareness of this issue to surface, and many will want to increase their contributions. I would argue that government pensions policy should create an environment that encourages people in every sector of the economy to save more.
What is a ‘normal’ person?
It seems reasonable to consider that someone we see as a ‘normal person’ would be a basic rate taxpayer. But paying higher-rate tax is becoming the norm. The number of higher-rate taxpayers has increased – from 4.2m in the 2017–2018 tax year, to 6.3m in 2024–2025.
Over the coming years, fiscal drag will bring even more people into the 40% tax bracket. 7.8m people (20% of all taxpayers) will be in the higher bracket by 2027–2028, according to projections by the Institute for Fiscal Studies.
This matters because pension changes made by the Government at this point may eventually catch up with people who don’t expect to be affected. And they may be the very people who then realise that they haven’t saved enough for their retirement.
Will Rachel Reeves reduce pension tax relief?
One particularly strong rumour in recent weeks has been the suggestion that Rachel Reeves will cut pension tax relief in the Budget.
At present, anyone who pays pension contributions receives tax relief at their marginal rate. Officially these rates are either 20%, 40% or 45%. However, the gradual removal of the Personal Allowance on earnings between £100,000 and £120,000 means that marginal tax for those individuals is actually 60%.
The current tax relief structure makes pension contributions tax-efficient for everyone. This is particularly the case for those people earning between £100,000 and £120,000, who can use their contributions to avoid paying tax at 60%.
Opponents of this structure argue that relief is concentrated on the highest earners. While this is true, it’s simply a reflection that those who earn the most also pay the most tax.
An alternative structure might see tax relief set at 30%. Such an approach does have some merit, but on balance I think it would prove detrimental.
Setting pension tax relief at 30% would be great news (in the short term at least) for basic rate taxpayers, who would see their pension contributions augmented by the state, resulting in a faster accumulation of their pension pot. However, for other taxpayers, the change would be less welcome.
Tax relief at 30% would mean that a higher-rate taxpayer would pay 10% tax on their pension contributions. The funds invested would then accumulate tax-free. However, once that higher-rate taxpayer retired, under the current tax structure they would be likely to receive a quarter of the accumulated pot tax-free and pay 20% tax on the balance. This is equivalent to a tax rate in retirement of 15%.
Higher-rate taxpayers would need to weigh up how this tax incentive compares to an immediate 40% tax charge followed by tax-free growth and tax-free income if invested in an ISA. For many, greater ease of access to savings might tip the balance in favour of the latter approach.
A government policy which increases the attraction of savings vehicles offering immediate access may not prove conducive to long-term pension saving.
Another drawback of changing the tax relief system is that once changed, what is to stop a future government changing it again – perhaps reducing the 30% to 25%, as per my example? Wariness of future government meddling with pension savings might offer a further incentive for higher rate taxpayers to save through ISAs instead.
Finally, as I noted earlier, fiscal drag will increase the number of individuals adversely impacted. For anyone who becomes a higher-rate taxpayer in future, the case for making pension contributions will have less appeal.
My expectation is that most individuals will make most of their pension savings later in their careers. And that’s exactly when they’re most likely to be higher-rate taxpayers. Young people are stretched financially, dealing with childcare and housing costs. For them, pensions tend to be tomorrow’s problem. When they reach an age, and income level when they can finally start to build up a pension pot, they’re far less likely to do so if tax relief is not available at their marginal rates.
As a nation, we’re saving far less for retirement than we should be. In my view, reducing tax relief would exacerbate this and would be detrimental to the long-term accumulation of pensions savings. For this reason, I strongly oppose such a change.
Should we reduce the tax-free lump sum?
Under the current rules, individuals retiring from a DC pension arrangement can take a quarter of their accumulated pot as a tax-free lump sum. This is subject to a maximum amount of £268,000, meaning that anyone retiring with a pot lower than £1.07m (i.e. most people) will be able to take a quarter of that amount tax-free.
If the tax-free lump sum were to be reduced to £100,000, for example, anyone retiring with a pension pot of more than £400,000 would be impacted. As I noted earlier, despite the likely public perception that a pension pot of this size is huge, the reality is that it’s well below the level required to deliver the retirement lifestyle that many people expect.
One further point to note is that while public interest in and understanding of pensions tend to be limited, the existence of the tax-free lump sum is both well known and popular. Reducing the tax-free amount would send out a damaging message and would present a disincentive to save among those people who really should be saving more.
I accept that the current tax-free limit is generous, but reducing it even slightly sets a precedent that future chancellors might choose to follow. This would be unhelpful. My preference would be to maintain the current level of £268,000. Fiscal drag will mean this affects an increasing number of retirees over time.
Employer National Insurance
At present, employers don’t pay National Insurance (NI) on contributions to workplace pensions.
Changing this would directly increase staffing costs, and it seems likely that many employers would respond by cutting costs elsewhere. For employers currently paying more than the 3% required under auto-enrolment, one option would be to reduce pension contributions. Alternatively, employers might scale back on recruitment plans or restrict future salary rises. All these actions would ultimately result in lower employer pension contributions for employees.
As with the previous two rumours, I look at this potential change from my standpoint that pension savings are generally insufficient. It seems inevitable that adding employer NI to pension contributions would result in at least some employers paying less into pensions – not a desirable outcome.
Changes to inheritance tax
Under the current rules, DC pots are almost always excluded from an estate when an individual dies – in other words they aren’t subject to inheritance tax.
This is not the case with other types of saving, and means that many individuals will draw on those alternative sources in retirement before touching their pension. This is a logical approach because if they die with money left in their pension pot, it can be passed on as tax-free inheritance.
However, the purpose of saving in a pension vehicle should be to provide financial support for an individual in retirement. So it does seem an anomaly that retirement savings can be used as a means of inheritance tax planning. Revising the rules to include DC pots within the deceased’s estate does not strike me as an unreasonable change.
That said, there may be unintended consequences for individuals who expect their estate to be subject to inheritance tax. The current rules encourage a cautious approach to the drawdown of pension savings, since the pensioner knows that if any of the pot is left over when they die, it can be passed on to their beneficiaries tax-free.
If that carrot is removed and the pensioner knows that any pension savings left over will be taxed at 40% on their death, they may see a greater incentive to draw down money sooner and accept an immediate 40% income tax charge. That money could then be spent or gifted to beneficiaries. Such action may result in excessive early drawdown of pensions savings and increase the number of pensioners becoming dependent on the state in later life.
As I said, I don’t think bringing pension pots into a deceased’s estate would be an unreasonable change, but it might exacerbate the risk of pensioners drawing down their pension too quickly. One solution might be to require pensioners to secure a minimum level of income before being allowed to implement drawdown on the remainder of their pot.
Finally, a plea
Most people are not saving enough for retirement. Many are unaware that this is the case – a typical view being that they have been auto-enrolled, and because their contributions are at the level recommended by government recommends, they’ll be alright.
There is a huge exercise required to educate the public on the size of retirement savings required, but we need a stable tax and regulatory regime to achieve that. It’s difficult to suggest that someone should increase their pension contributions if the belief persists that government (of whatever colour) will simply change the rules in the future and grab a bigger share of the pot.
Rumours such as the ones I’ve set out in this blog post circulate ahead of every budget. But they’re unhelpful, and I would urge all politicians to stop using pensions as a political football. Pension savings are a long-term commitment to the future, and we need a long-term commitment from MPs to stop moving the goalposts.
None of the points made in this blog post constitute financial advice.