Perception is a powerful thing.
Consider our attitude towards the personal allowance. All else being equal, someone earning £10,000 a year is unlikely to reject a large pay rise purely because they will pay income tax on most of the extra money.
The personal allowance is seen simply as a ‘band’ of income which is exempt from tax; a threshold above which the tax treatment changes.
In contrast, consider the annual allowance. It is another allowance, so logically we should think of it in a similar way: as a band of pension contributions which is exempt from income tax. Instead, most investors view the annual allowance as a strict limit, and strive to avoid exceeding it at all costs.
Perhaps this is due to the way the annual allowance is typically described.
Given the time, we can explain that pension contributions are exempt from income tax (up to the value of the individual’s income), outline the mechanics of tax relief, and explain how the annual allowance limits the overall amount of tax relief.
Limiting language
But most summaries, particularly those written for investors, tend to describe the annual allowance as ‘a limit on the contributions you can make each year’, or something to that effect. Such descriptions are simplified to the point of being woefully inaccurate, and perpetuate this image of the annual allowance as a restriction on contributions.
Factor in the money purchase annual allowance, carry forward and the tapered annual allowance, and the rules get horribly complicated. As an industry, we commit an enormous amount of time and effort to helping clients ‘maximise’ their pension contributions. Staying within the annual allowance, whatever it may be for each individual, appears to be the key objective for many. But with so many restrictions and the allowances continually dropping, is this the best strategy?
Going back to the personal allowance and income tax: we recognise, albeit somewhat grudgingly, that as our income increases past the thresholds, we receive a smaller share of the additional money. But again, all other things being equal, few would argue this as a reason to reject a higher income. We consider it worth having a smaller amount of something extra, rather than nothing at all.
By this logic, far fewer people would be as concerned with ensuring their pension does not exceed the lifetime allowance (LTA). All sorts of inventive plans are put into action to keep pensions below the LTA and in this context, investors seem to ignore the net gain they would generally receive from the funds above the threshold.
I appreciate that in many cases, it would make little sense to continue contributing if the money would very shortly be penalised for exceeding the LTA, leaving the investor with less than they paid in. But what about pensions which will exceed due to investment growth? What about cases where an employer is funding the pension, and there would be no replacement benefit if the contributions were refused? In these scenarios, rigidly remaining within the LTA would leave the investor with less money.
Retirement needs
These perceptions were formed when both allowances were considerably higher, and for the majority of people there was little possibility of exceeding either, nor any reason to do so. The risk is that if these perceptions persist now the allowances are much lower, it could be at the expense of a much more fundamental issue: how much does the individual need to meet his or her retirement aims?
Of course, many investors who reduce their contributions will be diverting the funds to alternative savings vehicles still earmarked for retirement. But I also suspect there are many who are not. Additionally, some of the strategies people use to remain within the LTA involve taking benefits much earlier or in a different way than they’d intended, which could have a huge effect on their retirement plans.
Compared to the allowances, which have changed dramatically over a short space of time, an investor’s idea of how much they need to fund their retirement will be relatively consistent. We need to make sure that investors don’t let the perceptions of the allowances stand in the way of achieving their aims.
Jessica List is pensions technical analyst at Suffolk Life.
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