Previous Chancellors have shied away from slashing generous pension top-ups, but Rachel Reeves is short on easy options to fill a black hole in the country’s finances.
A raid on millions of better-off pension savers could raise billions of pounds, though the practical obstacles would be daunting and the move would inevitably provoke a storm of protests.
The huge cost of subsidising pension savings via tax relief will always make it a tempting target when the Treasury looks for cost cuts.
Recent official figures show the total bill rose to £52.5billion in 2023/24, up from £50.1billion the year before, and most of it went to higher and additional rate taxpayers.
So, despite the big challenges involved, there is always a risk that any Government is going to become so desperate for cash that it demolishes the present pension tax regime and rebuilds one far less favourable to many savers.
How does the Government currently boost pensions via tax relief, and what would an overhaul of the long-established system mean for savers.
Flat rate pension tax relief: Critics say it would punish younger savers who wouldn’t get the same boost to retirement funds older generations enjoyed
What is pension tax relief?
The major perk of saving into a pension is that you do it out of untaxed income.
You receive rebates, effectively free cash from the Government paid into your pension, based on your income tax rate of 20 per cent, 40 per cent or 45 per cent (Scotland’s tax rates are different).
The tax relief you get on contributions makes pensions a very efficient way to save, especially as many people are being pushed into higher tax bands due to Reeves already freezing thresholds until 2028 at the earliest.
The system is tilted in favour of the better-off because they pay more tax – see below.
Speculation about possible changes usually revolve around the introduction of a flat rate, where higher and additional rate taxpayers receive a reduced level of relief, and basic rate taxpayers either get the same or a bit more than now.
The Government would be stingier in setting a new single rate if it was trying to save more money, and afterwards could probably move it up and down pretty much at will.
Estimated proportion of income tax relief on total pension contributions in 2023/24 by the rate of relief Source: HMRC)
Will pension tax relief be raided in the Budget?
Overhauling pension tax relief would be a major endeavour rather than a quick cash-raiser, or it would have been done long ago.
There are objections based on fairness, before you get started on the practical difficulties.
Critics say it would punish younger savers who wouldn’t get the same boost to their pension fund that older generations enjoyed.
With more working people moving into higher rate tax bands due to frozen thresholds causing ‘fiscal drag’, an increasing number would see their savings stymied by smaller top-ups than were previously handed out.
The move would also run counter to two other major Government objectives: getting people to save more into pensions, which it has just launched a Commission to address; and ramping up pension investments to boost the economy, on which it has also launched high profile initiatives.
Meanwhile, speculation about slashing pension tax relief always prompts a flood of extra money into retirement funds, which causes a spike in the Government’s bill until the changes fail to materialise.
This happened again last summer and autumn, even though Reeves had reportedly cooled on the idea some time before the Budget.
John Havard, a consultant at tax adviser Blick Rothenberg, says: ‘Rachel Reeves has taken all her easy choices for increasing tax revenue off the table by sticking with her manifesto promises [on income tax, NI, VAT and corporation tax]. But one option that remains open to her is targeting pension tax reliefs.
‘The Government’s argument will likely be that as a disproportionate percentage of relief goes to fund the retirements of the “better off”, it is not fair for “ordinary working people” to be subsidising the retirement of the “wealthy”.’
But Havard says auto enrolment has added large numbers of workers to the pool of individuals benefiting from tax relief on pension contributions, and changes by the Coalition government in the earlier 2010s greatly restricted how much relief can be claimed by the highest earners.
‘The Chancellor could restrict pension tax relief to the basic rate of tax. But lots of “ordinary working people” pay the higher 40 per cent taxation rate.
‘If the imperative is to collect lots of money quickly, it might be necessary to make those paying 40 per cent tax losers as well as those who are paying the 45 per cent rate.’
Tom Selby, director of public policy at AJ Bell, says: ‘Younger workers who already, on average, benefit from less generous workplace pensions than their parents and grandparents would now also miss out on the potential benefit of higher-rate pension tax relief as they progress through their careers.’
He adds that the £50billion-plus cost of pension tax relief can be misleading.
‘A huge chunk of that money relates to National Insurance relief on employer contributions, meaning it is mainly firms, rather than individuals, who are benefiting.
‘Given employers have already been clobbered by National Insurance rises at the last Budget and the Government has put economic growth at the centre of its strategy, it is hard to imagine lumping extra costs on the businesses who will ultimately deliver that growth will be particularly appealing.’
Selby adds: ‘Those who repeatedly push for radical tax relief reform have yet to spell out exactly how it would be applied practically.’
Rachel Reeves: Previous Chancellors have shied away from reforming pension tax relief
Why is it so hard to reform pension tax relief?
In the run-up to the last Budget, finance experts explained that moving to flat rate tax relief would require radical changes to the entire pension system.
The downsides include a clash with salary sacrifice contributions, and complications with final salary pensions – which could even spark public sector strikes.
Salary sacrifice: These schemes allow employers and their staff to cut their National Insurance payments. You agree to a cut in salary and your employer boosts its contributions to your pension in exchange.
New administrative arrangements would be needed under a flat pension tax relief system. Here’s an explanation of how the mechanics of salary sacrifice would change.
Just banning the practice would be unpopular and probably would not work over the longer run because employers could give incoming new staff bigger pension contributions and lower salaries.
Final salary (defined benefit) pensions: These generous pensions which pay out a guaranteed income until you die have been almost entirely phased out unless you work in the public sector.
These value employer pension tax relief in a different, more complicated way than the defined contribution pension schemes that prevail in the private sector.
Fixing this to work under a flat rate system could either upset the higher earners or the lower earners within the same scheme, depending on how the issue was tackled – which is why some experts predict this could lead to strikes.
Simply exempting public sector schemes from flat rate pension tax relief would not go down well with huge swathes of workers either.
Money experts explain how pension tax relief works in defined benefit schemes here. See the final section: Will the Chancellor take axe to pension tax relief for higher earners?
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