How will pension investors respond to the lifetime allowance freeze?

Our head of pensions and savings Becky O’Connor discusses what the behavioural response likely to be.

The Office for Budget Responsibility has said there is a high degree of uncertainty around the impact of the LTA freeze, because it is hard to predict what people will do in response.

The OBR Economic and Fiscal Outlook published alongside the Budget yesterday says about the pensions lifetime allowance (LTA) freeze: “This measure freezes the limit on the amount of tax-relieved pension savings an individual can accumulate over their lifetime at its current level of £1,073,100 until 2025-26. This generates an Exchequer yield via additional income tax and NICS receipts from individuals reducing their pension contributions, as well as from LTA charges paid by those who accumulate pension savings above the limit. The main reason we assign this costing a ‘high’ uncertainty rating is around the extent of the behavioural response”.

So what is this behavioural response likely to be?

Becky O’Connor, Head of Pensions and Savings, interactive investor, says: “For those who think they might reach the lifetime allowance limit in the next five years, these additional tax charges will look intimidating. As the OBR says, how much the government raises from freezing this allowance until 2026 depends on how people respond to it, with revenue to be raised either from people reducing their pension contributions, which saves the government money in tax relief not applied, or through hitting the LTA limit and paying additional tax charges.

“There is a chance we could now see people crystallising their pension funds earlier than they had been planning, to try to prevent their pot reaching the LTA. It could also lead to some people slowing or stopping contributions. But the tax charge doesn’t mean pension contributions are automatically no longer worth making, as employer contributions and tax relief can compensate for charges due.

“While it might looks like these pension investors are damned if they do keep paying in and damned if they don’t, there are some things people can do if they are worried about reaching this amount. The first thing to do is simply be mindful of it as you build your pension and approach 55 (or 57, if the new higher minimum pension age will apply to you), when you can access your pension for the first time. The moment you access your pension for the first time is the first ‘test’ of your pension against the lifetime allowance, so its value at this point is important.

“The second thing to do would be to use your ISA for retirement income, too. That is an additional £20,000 a year to invest tax-free, with no limits above which charges will apply.

“If you have exhausted your ISA allowances already, it may still be worth paying into a pension, even with an LTA charge looming, if you are receiving employer-matched contributions and higher-rate tax relief – as the ‘free’ amount going in should still be greater than the tax charge.

“If you are already over 55 and now worried about contributing more to your pension because you will face another LTA test at 75, how you manage your pension in the intervening years between when you first access your pension and the next LTA test at 75 will be important.”

What are pension investors likely to do?

1. Forpeople still building up their pot and some way from retirement – the LTA freeze will probably not have a significant impact, but those who think they might be hit by charges for going over the LTA limit need to be more mindful of it. People may certainly pay in less if they think the LTA is a threat, especially before they have an opportunity to crystallise, because it is at this point they could fail the LTA test.

2.  For those approaching / in retirement - This could drive people into crystallising funds earlier once they have reached 55, to ensure they don’t trigger a charge for going over the LTA when they do crystallise – which could lead to them stopping contributions. Once someone has started accessing their pot, they have until 75 to manage their pension value in relation to the LTA, to make sure it does not trigger a charge when the LTA is tested again at 75. They can manage this by taking taxed income and not paying in contributions. 

Becky says: “In the meantime, pension investors who are not immediately concerned by the LTA freeze need to make sure they are taking full advantage of reliefs and allowances available to them.

This includes the annual allowance of £40,000 (and carry forward up to the last three years) and tax relief.

Higher and additional rate taxpayers should also ensure they are not missing out on tax relief by failing to claim it through their tax return.

Not all higher and additional rate taxpayers need to do this – if their employer is claiming their relief for them and adding it to their contributions, they don’t need to do anything. But if your employer does not add it automatically, you could be missing out on higher or additional rate tax relief by failing to claim it.”