AJ Bell: defined benefit pensions may get 76% more

Salford-based investment platform AJ Bell said on Tuesday its analysis shows that — due to a tax quirk — defined benefit (DB) pension members could have an income 76% higher than an equivalent defined contribution (DC) saver without breaching the lifetime allowance.

AJ Bell said the disparity exists “because HMRC uses an out-of-date ‘multiplier’ to turn a guaranteed DB income into a notional fund value to test against the lifetime allowance.”

This means someone in a DB scheme could have a guaranteed, inflation-protected income worth £53,655 without breaching the £1,073,100 lifetime allowance.

By contrast, a healthy 66-year-old DC saver could buy an equivalent guaranteed income from an insurance company with a £1,073,100 pot worth £30,418.

AJ Bell senior analyst Tom Selby said: “While it is common knowledge that workplace defined contribution pensions are often the poor relation to generous defined benefit schemes, there is a lesser known tax quirk which creates a huge disparity in the maximum retirement income someone can generate without breaching the lifetime allowance.

“On a conservative estimate, this quirk means DB members can enjoy a 76% higher retirement income than their DC counterparts without being hit with a lifetime allowance charge.

“The is because the ‘multiplier’ used to convert a DB income into a notional fund to test it against the lifetime allowance is woefully out of date, having been introduced in the mid-2000s when annuity rates were much more generous than they are today.

“This disparity was hard to justify during normal times but as the country prepares to end lockdown restrictions and with the Government facing huge fiscal challenges as a result of the pandemic, it now seems ripe for review.

“However, addressing what looks like an anomaly would likely create a huge row with the public sector – including doctors who have worked on the frontline during the pandemic.”

Selby explained how the lifetime allowance “multiplier” favours DB savers.

“The current lifetime allowance is £1,073,100 – a figure which will not change for the rest of this Parliament following Chancellor Rishi Sunak’s decision to freeze the limit at the March Budget,” he wrote.

“Because DB members build up a right to a retirement income rather than a pot of money, a ‘multiplier’ is used to covert the income entitlement into a notional fund.

“This is then ‘tested’ against the lifetime allowance when the person starts receiving their pension.

“This multiplier is set at 20, meaning whatever income a DB member is entitled to is multiplied by 20 to give a figure which is tested against the lifetime allowance.

“So if, for example, a DB member received an inflation-protected pension income of £20,000 a year from their scheme, for the purposes of the lifetime allowance this would be multiplied by 20 to give a notional fund value of £400,000.

“The maximum income a DB saver could take without breaching the lifetime allowance is therefore £53,655 (20 x £53,655 = £1,073,100).

“DB schemes also usually offer to pay at least half of their guaranteed income to their spouse when they die (often referred to as a ‘spouse’s pension’).

“If a DC saver wanted to buy a DB-equivalent income, they would need to go to an insurer and purchase an annuity.

“Assuming they didn’t take tax-free cash, the maximum inflation-protected join-life annuity paying a 50% spouse’s pension a healthy 66-year-old (state pension age) could buy with £1,073,100 is just £30,418, according to the Money Helper annuity calculator.”

Explaining a possible solution, Selby wrote: “There are different policy options the Treasury could pursue to remedy this unfairness.

“If it is intent on retaining the lifetime allowance, then updating the multiplier to better reflect current annuity rates would be the obvious solution.

“However, there is an argument a more fundamental rethink of the way tax relief costs are controlled between DB and DC schemes should be considered, with a single annual allowance for DC and a single lifetime allowance for DB.

“This would at a stroke remove the lifetime allowance unfairness, solve many of the issues the annual allowance creates for people accruing benefits in DB schemes and generally simplify the system for the majority.”

About the Author

Mark McSherry
Dalriada Media LLC sites are edited by veteran news journalist Mark McSherry, a former staff editor and reporter with Reuters, Bloomberg and major newspapers including the South China Morning Post, London's Sunday Times and The Scotsman. McSherry's journalism has also appeared in The Washington Post, The Guardian, The Independent, The New York Times, London's Evening Standard and Forbes. McSherry is also a professor of journalism and communication arts in universities and colleges in New York City. Scottish-born McSherry has an MBA from the University of Edinburgh and a Certificate in Global Affairs from New York University.