One of the headline announcements of the budget on 15 March was the scrapping of the lifetime allowance for private pensions. The allowance – which currently stands at just over £1 million – is the maximum that an individual can draw from their pension in their lifetime without paying additional tax.

Unsurprisingly, this policy, which will come into force from April 2024, has been criticised by some commentators, as it is higher earners who are likely to benefit most.

How does the UK pension system work?

Crudely speaking, the UK pension system assumes that a pensioner will get income from two sources: the basic state pension and a private pension. There are also other benefits for people who are poor or who have disabilities.

Currently, the basic state pension is £141.85 per week or £7,376.20 per year, which is not enough to live on. Most people will also have some sort of private pension – this may be provided by the employer or it will be a ‘personal pension’ – consisting of income paid out from pension savings accumulated over one’s working life.

The cumulated pension savings at the point of retirement can be thought of as a ‘pension pot’, which will be used to finance retirement. The lifetime allowance applies to this pension pot and puts a maximum on the total amount of money in it.

To encourage people to save in a private pension, any income that is paid into the pension is paid before income tax and national insurance contributions – effectively one gets tax relief when saving. No tax is paid at all on any returns in pension savings (dividends or interest).

When the pension is received, it will be taxed at a lower rate (since pension income is typically lower than employment income and income taxes are progressive; further, pensioners do not pay national insurance, which is a tax in all but name). In addition, when someone retires and starts to draw the pension, 25% of the pension saving can be taken as a tax-free lump sum. As a result, taxes are only paid on 75% of the total savings.

It is unclear whether this tax relief has a significant effect on pension saving. Nevertheless, it clearly does provide incentives for people to put savings into pensions as a way of avoiding income tax and other taxes.

What is the purpose of a lifetime allowance?

If a pensioner dies before drawing the pension, then the pension savings are not liable to inheritance tax. The rationale for the lifetime allowance is that it puts a cap on the amount of money in the pension pot and hence prevents rich people from using the pension scheme purely for tax avoidance.

The explicit lifetime allowance was part of a major reform to simplify pensions introduced by the Labour government in 2006. At that time, the life allowance was £1,500,000.

If a single man had used the entire allowance to purchase a pension for himself via an annuity (that is, a constant income for life) then, given the annuity rates available at that time, the annual pension income would have been just over £100,000. If the man were married and had purchased a pension for himself and his wife, rising over time partly to compensate for inflation (to pay out so long as both were alive), the annual income would have been about £70,000. These are very generous pensions and so the lifetime allowance would have placed little restriction on most people.

What are the effects of a lifetime allowance?

The problem of the lifetime allowance arose for two reasons. First, the Conservative/Liberal Democrat and then Conservative administrations cut the lifetime allowance to only £1,000,000 by 2016.

Second, during this period, interest rates fell and annuity rates (which track interest rates closely) thus fell too. By 2016, just after the Brexit referendum, the maximum annual pension income available for a single man, given both the cut to the lifetime allowance and the fall in annuity rates, was about £45,000 and for a couple it might have been as low as £35,000.

While these pensions may still seem quite generous annual incomes for an average household, they are actually lower than would be expected by a senior professional (such as a doctor or head teacher). This created perverse incentives for highly-paid workers close to the end of their working lives, encouraging them to take early retirement, which causes staffing problems for organisations like the NHS.

It is notable that this problem is partly due to the design of the lifetime allowance and partly due to poor decision-making.

Setting the lifetime allowance at a fixed level, perhaps rising in line with inflation, means that changes in annuity rates result in changes to how many people are affected. Suppose the annuity rate for a couple is currently 5% and consider a couple about to retire with a pension pot equal to the lifetime allowance of £1,000,000 and thus expecting a pension of £50,000 a year.

What happens if the annuity rate falls to 4.5%, perhaps because of an unrelated change in interest rates? Most pension providers will try to hedge the pension pot, so that changes in annuity rates are offset by changes in the assets in the pension pot.

If the pension provider hedges successfully, the change in the annuity rate will be accompanied by the assets in the pension pot rising to £1,111,111 and hence the pension payable will be 4.5% × £1,111,111 = £50,000. But at this point the pension pot exceeds the lifetime allowance resulting in a tax surcharge on £111,111.

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