Anthony Hilton: George Osborne's pensions balancing act

In his last Budget, Chancellor George Osborne raised the idea that pension saving should be treated in the same way as ISA saving, and promised to consult on it.

That consultation ends this week, and most comments from the pensions industry are that it would be a bad idea.

Under the current system, pension contributions attract tax relief; they would not if they became like ISAs. There would be other reliefs — as there are with ISAs — but the big upfront tax bonus would be lost. This tax perk was only introduced because it was thought people would need an inducement if they were to be persuaded to lock their money away for 20 years or more.

There are at least two powerful reasons why Osborne would want to change the current system.

The first is that pension tax relief costs the Treasury over £30 billion a year. Osborne wants to balance the budget. If he can find a way not to have to pay all that money back to savers, he will surely take it.

His political future depends on creating the impression the books are in balance, and he is shrewd enough to know that when that time comes, no one will look in too much detail at how it was achieved.

The second problem is that when Osborne introduced pension freedom, which allows people to take their pensions savings as a cash lump sum rather than as a stream of income generated by the purchase of an annuity, he failed to think through how the freedom could be used to avoid tax.

If, for example, a high-earning 54-year-old were to put £40,000 into a pension plan and get immediate tax relief at 40% worth £16,000, this would reduce the cost of the investment to £24,000.

The following year, the person could cash in their £40,000 pot. Under the rules, a quarter would come out tax-free and the £30,000 balance would be taxed at the person’s marginal rate.

If they had retired, the chances are their tax rate on the remainder would be at the lower 20% rate, costing a maximum of £6000 — less if one factors the personal allowance.

So their net £24,000 of saving would have turned into a net £34,000 — a gain of £10,000 — for no risk. A top-rate taxpayer would pay £6000, not £3000, but would still have a gain of £4000.

A Chancellor dedicated to stamping out tax avoidance might well be a bit embarrassed at having created such a loophole, and would understandably be on the lookout for a way to block it without appearing to have to do a U-turn.

An Isa regime for pensions would do the job. So, of course, would abolishing the right to take a quarter of the pension pot as a tax-free lump sum — though that might spark a serious political backlash.

In fact, the risks of backlash and complexity suggest that the sudden overnight abolition of pension tax relief is unlikely because it would cause chaos and add hugely to costs.

Therefore, the smart money is on Osborne unveiling some kind of hybrid — enough of a move towards the Isa system to close the loophole and allow him to slash the amount he pays out in relief on contributions, but not getting rid of tax relief altogether — not yet anyway.