Cast your mind back to the late 1980s – Kylie and Jason were topping the charts, Scotland had a World Cup final appearance to look forward to and HM Revenue & Customs introduced the forerunner of the lifetime allowance (LTA) – the pensionable salary “earnings cap”.
The purpose of this was to restrict the maximum amount of pension someone could accrue without becoming “overfunded”.
The original “cap” was £60,000 for the 1989/90 tax year – thus giving a maximum pension of £40,000 (i.e. two-thirds of the cap).
For members of occupational defined contribution (DC) schemes, this pension could of course only be purchased if the underlying funds were sufficient to purchase such a sum.
Although defined benefit (DB) members did not bear the same investment risk, members of both arrangements were bound by the same maximum pension, regardless of how much that cost to secure.
Nowadays, much like the music scene, the pension landscape looks somewhat different than it did back in the 1980s. DB schemes continue to decline in favour of the finite cost of a DC arrangement.
While the LTA seeks to limit the amount of tax-privileged pension savings a member can accrue, it fundamentally disadvantages DC savers for the following reasons:
When applied against DB schemes, the maximum pension a member could achieve assuming an LTA of £1m would be £50,000 pa – i.e. using the capitalisation factor permitted of 20:1 and ignoring impact of any PCLS commutation.
Furthermore, in many DB schemes, the cost of ancillary benefits such as spouse’s pensions and/ or increases to pensions in payment are not “costed” against the LTA.
DC disadvantage
This approach significantly disadvantages DC savers for whom such benefits need to be explicitly paid for.
This is highlighted by the fact that a DC saver, with an accrued £1m pension pot, would only be able to secure a pension of about £30,000 – some 40% less than the equivalent DB saver.
Let’s return to the earnings cap we looked at earlier. We now have a position where a DC saver can no longer fund the maximum permissible pension from a generation ago without suffering a significant LTA charge!
This gives us a perverse situation where a DB saver, who bears no personal investment risk, can accrue significantly greater benefits than the equivalent DC save without any LTA penalty.
This position can be compounded due to the investment risk being borne by the DC saver and further still for those subject to the tapered annual allowance (“TAA”) expected to be introduced next month.
For those earning £210,000 and above their annual allowance will reduce to £10,000 – this represents a staggering 96% reduction from as recently as 2010/11 when the annual allowance was £255,000.
Hence, even if the DC saver could afford to make good a shortfall caused by a period of poor investment performance, the rules would not allow him to do so.
I accept that the Treasury need to ensure that the pension tax relief system is sustainable. However, the interaction of the AA and LTA can act as a barrier to ambition and prudent investment performance for DC savers.
It remains to be seen how sustainable DB pensions are in the public sector in the longer term.
Imagine the scene
However, imagine the government telling any public servant entitled to a £50,000 pension that they now need to accrue a fund of about £1.65m to purchase this sum.
Add to the mix that such funding would potentially be subject to a six-figure LTA charge and you can almost see the picket lines forming.
Next week’s Budget presents a prime opportunity to level the DB/DC playing field.
We can but hope (never a truer word spoken by a Scotland fan) there aren’t too many broken hearts for DC savers once the contents of the despatch box are known!
Mark Canning is national head of business development at Yorsipp
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