Standard Life PBR comment - impact of higher rate tax changes on pensions savings

Increase in top tax rate could make pensions saving more attractive to high earners.

Confirmation that the UK's highest earners (?150,000 plus) will pay 45% tax on income was received in the pre-budget statement today.

It is accepted theory that when tax rates rise, the desire to avoid them also rises e.g http://www.econlib.org/library/Enc1/SupplySideEconomics.html.

Top rate income taxpayers are therefore more likely to use pensions as a way to avoid paying the highest rates of income tax.

The maximum fund that can be built up in a tax efficient way (the "lifetime allowance") is currently ?1.65 million (2008/09).

Any excess over ?1.65 million is taxed at 55% but this excess amount can be taken as a lump sum.

55% may not seem like a price worth paying to get pension tax relief.

However, the higher the rate of tax relief on pensions, the more likely it is that investors will become willing to pay the 55% exit tax charge.

At present, it takes around 18 years, on return assumptions of 3.5%(1) real (pension) versus 1.45%(1) real (net fund investment such as unit trust, OEIC or insurance bond), before pension saving with 40% tax relief and a 55% tax charge ("lifetime allowance charge") beats saving in a net fund investment.

But increasing the rate of tax relief to 45% means that pension saving now produces a higher return after 16 years based on these same assumptions.(2) John Lawson, Head of Pensions Policy at Standard Life said, "The UK's highest earners now have an added incentive to shelter their income within a pension.

Longer-term investors may even want to deliberately exceed the lifetime allowance and pay a 55% tax charge, as this may produce a better return than investing in an equivalent mutual fund." (1) e.g assume inflation of 3% - gross nominal return on pension fund is 6.5% (3% inflation plus 3.5% real return).

If 4% of this nominal return is from income and 2.5% from capital gains, then the net returns for a higher rate taxpayer on these elements will be 2.4% on income (4% less 40% tax) and 2.05% on gains (2.5% less 18% tax) giving a net return of 4.45%.

Discounting for inflation of 3% gives real rates of return of 6.5% (pension) and 1.45% (net investment held by a higher rate taxpayer).

(2) calculations in this spreadsheet 24 November 2008.

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