George Osborne's pension reforms will have consequences for tax relief

George Osborne used his March 2014 budget speech to announce a major change to the way pensions operate in the UK. From April next year there will be no obligation for people cashing in a pension pot to purchase an annuity. Under the existing regulations, anyone in a defined contribution scheme with a pension pot bigger than £30,000 (increased from £18,000 in the Budget) is required to purchase an annuity, after taking up to one-quarter of their savings in the form of a tax-free lump sum. Only those with a secure pension of £12,000 (reduced from £20,000 in the budget) can opt instead for a drawdown pension.

Once the new system comes into force, anyone with a pension pot will be able to cash in the whole amount and do with it whatever they like – though they will have to pay tax on any amount cashed in over and above the tax-free lump sum. This will have ramifications in a number of areas, from the housing market – if it leads to increased demand for buy-to-let properties – to the financing of social care – if people choose to spend most of their pension savings in the early years of their retirement.

The changes will also have consequences for the tax relief given to pension savings. The Labour party has already said that it would reduce the rate of tax relief on pension contributions from 45p to 20p for those earning over £150,000 (to fund a job guarantee for young people). More fundamentally, pensions minister Steve Webb gave an interview in which he came out in favour of a single rate of tax relief.

In fact, the Coalition has already cut tax relief. Most recently, from 2014/15 the annual limit on pension saving has been cut to £40,000 (from £50,000) and the lifetime limit to £1.25 million (from £1.5 million). It estimates this will boost revenues by £1.1 billion in 2017/18.

The motive for this move was, however, largely financial, as part of the government's efforts to reduce the budget deficit. Now there is to be no obligation to cash in a pension pot to purchase an annuity, there is a strong case for a more fundamental look at the tax treatment of pensions.

Any review would have to encompass all aspects of tax relief, including whether it is still appropriate to give tax relief on pension contributions at higher rates, the annual and lifetime limits, and the tax-free lump sum. It could well conclude that giving people greater freedom over how they use their pension savings should be accompanied by a reduction in the tax advantage of pension savings relative to other savings.

In this respect, the tax-free lump sum is the biggest anomaly. Currently up to 25 per cent of a person's pension savings are free from tax on contributions, free from tax on any income earned, and free from tax when cashed in. Even with the new lower lifetime limit, this means someone could save over £300,000 completely tax-free, which is extraordinarily generous.

In a report published last year the Pensions Policy Institute estimated that abolishing the tax-free lump sum would lead to an increase in tax revenues of around £4 billion, or alternatively that capping it at £36,000 (which would affect one in four people taking a pension) would save £2 billion. One problem with such a move, if it was applied to current pension savings, is that it could be seen as retrospective taxation. However, applying it just to future savings means that the additional revenues would accumulate only gradually. While this might be the correct approach from a pension perspective, it would be little help for a government looking for reform of tax relief on pension savings to make a worthwhile contribution to deficit reduction or to fund additional spending in a priority area in the next parliament.

This consideration might lead the next government to prefer to take further steps to make the tax treatment of pension contributions less generous. For example, reducing the annual limit to, say, £30,000 and the lifetime limit to £1 million would raise well over £1 billion (because more people would be affected than were hit by the reductions to £40,000 and £1.15 million).

This, though, is still a relatively small sum compared to the projected deficit. Any government that wants to combine reform of tax relief for pensions with raising substantial tax revenues to fund extra spending or to help eliminate the budget deficit would have to consider abolishing higher rate tax relief on contributions. The Pension Policy Institute reports that this would reduce the cost of tax relief by £13 billion.

Government borrowing is going to cast a large shadow over next year's general election. Any promise to cut taxes or increase spending made by one of the three major parties will have to be accompanied by offsetting tax increases or spending cuts or risk the charge of profligacy. The chancellor has already cut tax relief on pension savings in the current parliament. His moves to give people more choice over what they do with their pension savings makes it more likely that the next government, whatever its composition, will cut it further.