The ABI has made suggestions about how the pensions tax relief system could be changed to make it more equal.

The insurance trade body’s suggestions came after it commissioned a report from the Pensions Policy Institute (PPI) which found that higher earners, who are more likely to be men, benefit most from the current system.

How does pension tax relief work?

Tax relief is effectively a “bonus” which tops up people’s pension savings, alongside their own contributions and those of their employers.

The more people earn, the higher the percentage rate at which their income is taxed. This means that paying into a pension and getting the tax relief that comes with it can be particularly advantageous for higher earners – many of whom are older males.

Tax relief is paid on your pension contributions at the highest rate of income tax you pay. So basic-rate taxpayers get 20% pension tax relief, higher-rate taxpayers 40%, and additional-rate taxpayers can claim 45% pension tax relief.

A basic rate taxpayer would need to contribute £80 for a £100 contribution into their pension (£20 is tax relief); a higher rate taxpayer £60 (£40 tax relief), and an additional rate taxpayer £55 (£45 tax relief).

Unfair system

The ABI-commissioned report said the skew towards people on higher incomes is magnified because, as well as being entitled to a higher rate of relief, they are also likely to have more cash available to put in their pension than lower earners.

It found people paying basic rate tax make up 83.4% of total taxpayers but only receive 26% of the pensions tax relief related to defined contribution (DC) pension contributions.

The research also found the number of people earning less than £30,000 who now qualify for tax relief has increased from 52% to 62% due to auto-enrolment into pensions. But only 24% of tax relief goes to people earning less than £30,000. Nearly three-quarters (71%) of DC pension tax relief goes to men.

Tim Pike, head of modelling at the PPI, says: “While automatic enrolment has significantly increased the number of low earners benefiting from tax relief on DC pension contributions, half of the value of this relief goes to people earning £60,000 or more.”

Report recommendations

The PPI research suggests a single “flat rate” could help distribute tax relief more evenly, while the ABI says the system needs to be changed so it’s fairer to all earners and encourages saving for retirement.

Yvonne Braun, director of long-term savings and protection at the ABI, says: “Pensions tax relief plays a vital role in encouraging people to save, but also in supporting the adequacy of that saving.

“However, the distribution of pensions tax relief under the current system exacerbates existing inequalities, particularly between men and women. We hope the research will provide food for thought on how to make the system simpler and fairer.”

Changing the system

Jon Greer, Quilter head of retirement policy, says: “While a flat rate of 30 to 33% would be re-distributive and benefit basic rate taxpayers, it would be broadly revenue neutral for the government. And this begs the question, what will they do next? Once pension tax relief is decoupled from marginal income tax rates it is a slippery slope and there would be little to prevent future governments then cutting tax relief to 25% or even 20% to save money.

Greer points out that income tax relief on pension contributions is not a relief in the conventional sense, but a tax deferral mechanism.  This is because income tax is applied on the way out, not on the way in.

“This tax deferral system creates an incentive to save for the future and ensures people are contributing some income tax later in life, helping to smooth fluctuations of demography and the pressures of an ageing society,” he adds.

James Riley, president of the Society of Pension Professionals (SPP), says changing the system will be far from easy – but needs doing.

He says: “In short, pensions tax needs to be simplified. Doing this properly however, will take time, careful planning and cross-party consensus. We need to ensure that we end up with a robust pensions tax system that is fit for the long term (and isn’t constantly tinkered with, as has been the case in the recent past). But we also need a system that is truly simple.”