Looking Ahead series: Autumn Budget 2024 - article six
One function of the lifetime allowance (LTA) was to limit the maximum amount of tax-free cash that could be taken from a pension to 25% of the LTA. When the LTA was abolished, a standalone cap (“the lump sum allowance”) was introduced. It was set at £268,275 – 25% of the 2022/23 LTA.
Whereas the LTA (and therefore 25% of the LTA) was originally intended to increase and, at least from 2018/19 had been due to increase with CPI inflation each year (albeit this was later frozen), there is no legislative provision for any indexation of the lump sum allowance. Its real value is set to fall over time – it will halve over 25 years if CPI inflation is 2.8%pa (the average over the past two decades).
If the Government wanted tax-free cash to fall further and faster, the lump sum allowance could be reduced in cash terms. The Resolution Foundation has suggested a £100,000 limit[1] but has since highlighted some of the practical difficulties[2]. More radical cuts, to around £36,000 (which would be higher in today’s price terms) were recommended in a 2015 Institute for Public Policy Research report, co-authored by Spencer Thompson, who now advises Rachel Reeves[3].
Unlike tax relief on contributions, the tax-free lump sum is an end-to-end reward for pension saving. It is also most advantageous to people who would otherwise pay 40% tax on withdrawals in retirement. Perhaps for these reasons, Lord MacPherson, who was Permanent Secretary to the Treasury from 2005 to 2016, recently said that there is “a really good case in principle to tax… the famous tax-free lump sum in pensions”. But he concluded: “I can tell you for free that’s not going to happen.”[4]
Both aspects of that assessment might reflect the institutional Treasury view: It seems unlikely in the extreme that, were HM Treasury designing a pensions tax system from scratch, it would allow so much income to escape tax altogether. However, it will be sensitive to public reactions. Discussing recent focus group findings, Janette Weir from Ignition House, said the tax-free 25% was the feature of the tax system that participants knew about, and that it was “fully ingrained” as a driver of decisions[5].
Moving the goalposts in relation to existing savings disrupts people’s plans at short notice - e.g. some will expect to use their tax-free lump sum to pay off their mortgage. With no transitional arrangements, the unanticipated tax bills could be large. For example, if the maximum tax-free lump sum were £100,000, someone with a £600k would have to pay tax on £50k of their £150k lump sum, which would typically mean a bill between £10k and £20k, and more in some circumstances. The difference in treatment between people accessing identical pots the day before/after a change took effect would also be unfair. Even if the lower maximum level made no difference to most savers, there would be fears that it could soon be reduced further, potentially leading savers to access their pots sooner than would otherwise make sense.
In addition, some people currently have protected tax-free lump sum entitlements, entitling them to amounts significantly greater than £268,275. Unless those protections were also abolished (and some of those protections might be expected to be held by individuals with significant influence), the accusation would be that tax-free lump sums for the wealthiest were being maintained, while those for “working people” whose pension pots were just comfortably above average were being confiscated.
Tapering the maximum down over time would make the differences less stark but at the expense of short-term revenue.
At the other extreme, confining the change to future pension contributions would for a long time produce little revenue. It would also focus tax rises on younger savers and on older workers who had planned to catch up with pension saving later in life (a choice permitted by a relatively high AA). And it would require everyone whose pension wealth is already more than four times the new limit to have their own protected tax-free cash amount. Would the political pain be worth the gain?
There would be a secondary effect on the public finances from unfunded public sector schemes. Although some designs include standalone lump sums, others offer members the chance to take a tax-free lump sum by converting £1 of annual pension into £12 of one-off cash. If less pension was “commuted” in this way, this could increase the eventual cost to taxpayers of providing public sector pensions but reduce the amount of cash that the Exchequer must find immediately.
If the Government did not protect existing tax-free lump sum “rights” i.e. the change affected rights already built up, it would be hugely contentious. Given this (and the nature of people likely to be affected), if there were any possibility of a legal challenge, a challenge would surely be made. In considering this option, HMT would have likely taken its own external legal advice and if it considered that there were any possibility of a challenge that might lead to the situation where its PCLS change had to be undone, it would make the potential consequences very clear to Ministers in its assessment of options. If the £268,275 (higher amount for individuals for whom protection had existed) maximum lump sum was taken away then later reinstated retrospectively, pension schemes (including in the public sector) might then need to restructure benefits that had in the meantime been put into payment, reducing pensions (some of which would have taken the form of annuity contracts) and topping up tax-free lump sums. The administration involved would be nightmarish.
Even if no legal challenge were possible, such a move would risk undermining saver and investor confidence – if a UK Government were to tax individuals’ assets previously built up in expectation that no tax would apply, might it or a future Government also do the same to a company’s or other investors’ assets built up in expectation of the continuation of an existing tax-break?
