It wasn't meant to be like this. After increasing taxes in her 2024 Budget, the Chancellor said "We don't need to come back for more, we've done that now, we've wiped the slate clean." But Rachel Reeves left herself only a small margin for error against fiscal rules that she said were ironclad, and forecast revisions moved against her.
On 4 November, delivering what the Government labelled her "scene setter speech", the Chancellor said the "reward" for getting Budget decisions right included "more resilient public finances – with the headroom to withstand global turbulence". In other words, it looks as though she plans more fiscal tightening than needed to restore her previous wriggle room, providing greater confidence that this really will be her last major tax-raising Budget. Any wish to build a war chest for pre-election giveaways would add to the tax rises or spending cuts that must be built into her plans for now.
Long before then, the press had been full of the usual pre-Budget speculation about possible changes to pensions taxation. Our series of articles before last year's Budget: UK pensions and the Autumn 2024 Budget discussed many different policy options in detail. Here we'll focus on a few proposals and what has been said recently.
Recent stories about salary sacrifice are the only ones that appear to have originated from inside Government. We discussed these in our earlier article: Sacrificing the future? Preparing for a Budget clampdown on pension salary sacrifice.
Shortly before last year's Budget, it was widely reported that the Chancellor was about to end employer (but not employee) National Insurance relief on all employer pension contributions. We will soon learn whether a more modest but still significant assault on National Insurance relief makes the cut this time. Any restriction on salary sacrifice would lead to higher employer costs and lower take-home pay in respect of affected workers. In 2022, a WTW survey found that 43% of (larger) employers using salary sacrifice for DC contributions redirected at least part of their NI saving into employees' pension pots; in these cases, pension contributions would automatically fall.
When the previous Government announced that the Lifetime Allowance was to be abolished, Torsten Bell, now the pensions minister, said this was a "bad idea" but that there was a "silver lining": HM Treasury had taken the opportunity to cap tax-free lump sums at 25% of what had been the LTA, creating a "cash cap" of £268,275 that "a future government may well cut…".
That ellipsis seemed ominous when it was reported that (2½ years on) Bell had been put in joint charge of Budget planning, alongside Minouche Shafik – an adviser to the Prime Minister – who had also supported cutting maximum tax-free cash in the past.
It seems less threatening now that several newspapers have reported that this will not happen after all, with one saying that Treasury officials had "confirmed" this. Leaving aside any possibility that these briefings are intended to lull revenue targets into a false sense of security, they set a precedent: what will people conclude if similar reassurance is not offered next year? HMRC recently emphasised that tax-free lump sums are not returnable; they can become heavily taxed unauthorised payments if the individual does not become entitled to a pension (including designating to drawdown) within six months.
Advocates of cutting maximum tax-free cash note that a zero tax rate is a bigger discount on 40% than on 20%, and question whether tax breaks should encourage people with big pension pots to save more. But implementing any reduction would involve a difficult trade-off between avoiding a long wait for meaningful revenue and not moving the goalposts for people who had already earmarked the money for something. There would, unavoidably, be unequal treatment between people crystallising their pensions at different times – whether that is the past vs the future, or the near future vs the distant future. Revealingly, one recent proposal, from the Fabian Society, said that "transitional protections would probably be needed for people near their pension age" but chose not to get into the tricky business of designing them.
In any case, with no plans to index the lump sum allowance, its real value will erode over time. Even if the Bank of England always hit its 2% inflation target, the inflation would erode half the purchasing power of the maximum lump sum over 35 years.
Before she became responsible for Labour's economic policy as Shadow Chancellor – Ms Reeves repeatedly advocated ending marginal rate relief on pension contributions. Asked in 2016 "what aspect of the tax system would you change?" she replied: "Pensions tax. I would make it fairer. Pensions tax relief seems to be geared towards the highest earners. I would rather have a flat rate of about 33%." Any policy along these lines would require some difficult design decisions around how to apply a flat rate of relief to employer contributions and defined benefit accrual, as we discussed in our article last year: Ending marginal rate tax relief on UK pension contributions.
Reports ahead of the October 2024 Budget said that this idea was considered but was dropped because of the difficulty in applying it to public sector schemes; one headline read "Reeves abandons pensions tax raid to spare teachers and nurses". If the Chancellor is still interested in such proposals, one of her new special advisers might try to talk her out of it: when working for the Institute for Fiscal Studies, David Sturrock wrote "The case for restricting higher rate relief is not good. The current system creates a more equal treatment of those who receive their income more or less evenly across years. If the desire is to raise taxes from higher earners, this is better done directly". One of his former colleagues, new IFS Director Helen Miller, put it well when she recently told a Committee of MPs that tax relief on pension contributions "is not a relief at all. You just have to decide when to tax pensions — at the front or at the end?...it is just a design of the tax system."
Some reports suggests that the freeze of tax thresholds will be extended (though the Chancellor allowed such speculation to build last year, before saying she would not do that). In that case, more employees will be eligible for 40% tax relief on contributions. The reported cost of tax relief – most of which relates to the revenue that would be raised if employees paid an upfront cost on the value of employer contributions – would rise, and speculation about future policy changes would heat up.
For a while, the Chancellor was expected to increase rates of income tax by 2p in the pound, as part of a "two up, two down" move that would also see the main rate of employee NICs lowered by 2p in the pound. This now appears to have been ruled out. However, the speculation serves as a reminder that, although most people can reasonably expect deferring income by saving in a pension to be tax-efficient, the size of the end-to-end fiscal reward is unknown until the retirement income derived from a pension contribution has been received.
To illustrate what the effects could have been – and might one day be if such a policy is ever implemented – assuming that State and other savings income use up the personal allowance:
One way to reassure the markets that the Government is serious about fiscal sustainability might be to announce an increase in State Pension Age. In a recent interview, the Chancellor said this was one of the "tools at our disposal". The two previous reviews of State Pension Age took over a year to complete and this one only got under way in July, so an announcement at the Budget would represent a significant acceleration in policy-making; nor has there been any suggestion that the reports commissioned to inform decisions have yet been received by ministers. An announcement in 2026 looks more likely.
