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Why would any chancellor cut the tax-free lump sum?

Getting rid of the tax-free lump sum would discourage people from saving into a pension, so why are there always rumours that it will be cut?

Why would any chancellor cut the tax-free lump sum?

As long as I have been in pensions the future of the tax-free lump sum has cropped up time and time again. Every year the question of abolition is posed and people look for clues for whether this is the year it will happen.

In 2002 chancellor Gordon Brown reassured everyone the tax-free lump sum would be safe in the hands of the government, and it formed an ongoing part of the pension simplification regime introduced in 2006.

However, the more cynical commentators took the change in name from ‘tax-free cash sum’ to ‘pension commencement lump sum’ as an omen for a tax-heavier future. In the past few years various think tanks have suggested its removal, including the Centre Forum (where former pensions minister Steve Webb worked for a while) and the Centre for Policy Studies.

The rumour mill

As the rumours have come and gone, some have taken action just in case. This approach came home to me at a conference I was doing this time last year, just before the introduction of the pension freedom rules, when one of the delegates, an accountant, told me he had a cheque for £500,000 in his pocket as he had just taken out his lump sum. You know, just to be safe.

Surprise, surprise, rumours were back again in 2016, with were reports the chancellor would scrap the 25% tax-free lump sum as part of a wider range of changes to tax relief on pension contributions, potentially saving the Treasury £4 billion.

Unsurprisingly, the rumours have apparently not led to any changes, as the Treasury told journalists last week that plans to overhaul pension tax relief would not go ahead in the Budget.

Was the chancellor ever likely to scrap the tax-free lump sum? More importantly, is he likely to do so in the future?

Leave aside for the moment the fact that if the chancellor eventually decides to go against nearly all public opinion and introduce the ISA-style pension tax regime on a taxed-exempt-exempt basis, the tax-free status of the lump sum will disappear anyway.

Why do away with the lump sum?

Under the current system, is there any reason to do away with the tax-free lump sum?

First, consider why higher earners receive higher rate relief. It is because they do not receive tax relief at all but tax deferral. They will pay tax when they take the money out of the pension and not when they put it in. The extra relief is the reward for deferring the consumption of that particular sum of money. It is an incentive to save.

It does not necessarily follow there should also be an extra tax-free element. The only reason for having it is as an extra reward for deferral.

However, many individuals do see the tax-free lump sum as the real incentive for pension saving. This issue is compounded by the fact many pension savers have earmarked the tax-free element of their pension plan to pay off a specific debt.

It will also be difficult to square the fact some defined benefit schemes offer either a lump sum alongside a lower annual accrual rate or even the ability to commute part of the pension for tax-free cash. The mechanism is integral to the schemes; and particularly in the case of public sector pensions, there would be real opposition to change.

The problem of transition

The other important question is: how would it be restricted?

The pension industry is full of situations in which there are transitional restrictions to protect the benefits accrued before the date of any change so the restriction only applies to the newly accruing benefits.

Would there simply be a blanket tax-free cash ban on any newly accruing benefits or would there be a limit to the maximum that could be taken at retirement?

In any event the savings to the chancellor would surely be slow in coming as it would only be the new accruals that carried no entitlement to tax-free cash.

From both an industry and a political perspective, the availability to take tax-free cash is increasingly regarded as an anomaly. From a saver’s perspective, however, it is perhaps the key reason for pension saving and any change to it would seriously affect future pension planning.

Again we are back to another perennial question: do we want people to save for pensions or not?

Mike Morrison is head of platform technical at AJ Bell.

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