How will this year’s pension changes impact the UK’s workforce?

Earlier this year the chancellor outlined a series of changes designed to help encourage people in the UK to stay in work. The government has addressed some of the pensions tax barriers that were resulting in unforseen penalties and resulting in key workers – such as doctors – leaving the workforce early. As a result, though, some opposition parties have branded his changes ‘the great tax giveaway’ – but is this right? 

We explore whether these changes are likely to fulfil the incentive of keeping people in work for longer, and what impact that might have on the UK’s finances in the future.

Tax Treatment of Pensions

The first thing to do is to understand how pensions are treated for tax purposes. Pensions are considered by HMRC to be deferred income, so savers don’t pay tax on the money which goes into a pension - instead, they pay tax on the income that they take from their pension in later life. This should really be described as tax deferment rather than tax relief.

The big tax advantage of a pension is that when savers reach retirement age they’re able to take 25% of their pension pot as tax free cash – and so that 25% of a pot is subject to tax ‘relief’. 

Because of that element of relief, there are restrictions on how much money can be saved into a pension and how much a person’s pension pot is allowed to grow to, before tax penalties apply.

The total amount of money that can go into a pension in any one year is called the Annual Allowance. This includes the money that an employee puts in, that their employer puts in and any tax relief. Prior to the budget this was set at £40,000. This rule was to stop very wealthy people putting money into pensions, just to avoid paying tax.

The maximum value of a savers pension pot at retirement, before penalties are applied, is called the Lifetime Allowance. Prior to the budget, this was set at £1,070,000. This rule was designed to stop employers designing massively generous pension schemes instead of paying higher salaries in order to avoid tax. 

For those who are over the age of 55 and access some of their pension, something called the Money Purchase Annual Allowance kick’s in, which means that in future years the maximum annual contribution falls by 90% to just £4,000. This rule is to discourage people from taking large amounts of money out of their pension and then paying it straight back in again, to get the tax benefits again for a second time on the same money.

So what changes did we see to pensions in the budget?

Changes to the pension Annual Allowance:

This was increased from £40k to £60k.  This obviously benefits the most highly paid workers who can afford to save the most, but the way in which it benefits them depends on whether they are in a Defined Contribution (DC) Scheme, or a Defined Benefit (DB) Scheme: 

• Defined Contribution Pension Scheme (DC): The type of pension scheme that most private sector firms provide to their employees. Here it’s fairly straight forward to work out how much someone has contributed in a year by adding up the employee contributions, employer contributions and any tax relief, with the total amount not being allowed to exceed the annual limit – which until recently was £40,000. If it does exceed the limit, savers get a tax penalty.
• Defined Benefit pension (DB), also known as final salary schemes: These are still quite prevalent in the public sector. In these schemes, employees see an increase in the retirement incomes that they will eventually receive, for each additional year that they work. That additional income in retirement comes at a cost to their employer, and actuaries determine what that cost to the employer is equivalent to, in cash terms. If that cash equivalent exceeds the annual allowance, then the employee could face an unexpected tax penalty. People had no realistic way to anticipate and mitigate this complex effect and these tax penalties were unexpected and unwelcome.

By increasing the annual allowance from £40k to £60k, less workers in DB schemes will receive unexpected tax penalties. This in turn will remove one of the disincentives which applied to highly paid public sector workers who were thinking of working for longer before retiring.

Those in DC schemes can save 50% more each year without breaching the tax allowance ceiling. The average contribution into a workplace DC scheme is around £3,000 per annum, so few people are likely to benefit from the increase in the annual allowance. The very wealthiest will therefore be able to save more and get more tax relief. 

Addressing the pensions gender gap

The other big change that will impact the UK’s pensions is the change to childcare provision. In England there’s currently free childcare for three- and four-year-olds, but not before that. The UK is facing a huge gender pensions gap, the main driver of which is women taking time out of the workplace to bring up kids and look after elderly relatives. 

What the chancellor's done to address this is extended the free childcare all the way down to six months. Now, from the point that a child reaches six months all the way to school age, they are entitled to free childcare, meaning that women don't have to take quite as much time out of their career as they had to in the past. 

In addition to the pre-school childcare, the wrap-around care (which includes breakfast clubs and after school clubs) has been very inconsistent across England, so the government has introduced a new set of laws that require local authorities to provide full wrap-around care that every child in England by the year 2026. 

This means that parents – but, in reality, mothers – don't have to stop work or work part time to the same extent, as full wrap-around care will be available. We hope that this will be a big contributor to closing the pensions gender gap, because it removes one of the biggest barriers to women being able to be in full time work.   

Will these changes to the pensions system help keep people in work for longer?

Whilst these changes will remove one of the disincentives which discourage wealthier workers from working more hours, and older workers working more years, there are many factors driving people’s decision to retire early.

These changes are a positive contribution to encouraging longer working lives but will need to be assessed as part of a wider package of measures, rather than being the one thing, or even the big thing that will make the difference.

The changes should, however, lead to bigger pension pots, which means that pensioners will pay more income tax on those higher pension incomes in the future. This means that there will be less reliance on retirement benefits from the state, which in turn means less of a tax burden falling on younger generations in the future.    

For the childcare changes though, because the wrap around care isn't coming in until 2026 and then you need two or three years to really be able to see the effect that's had, it might be the latter part of the decade before we see if the childcare changes are feeding through to closing the gender pensions  gap.