Pensions tax relief does little to encourage pension saving, particularly among low and medium earners, according to a report by the Pensions Policy Institute (PPI).
The report, Tax relief for pension saving in the UK, which has been sponsored by Age UK, the Institute and Faculty of Actuaries, Partnership and the Trades Union Congress (TUC), assesses the extent to which pension tax relief meets its objective of incentivising pension saving, and analyses options for reform.
The report found that the current pension tax relief system is tax-advantaged compared to other savings such as independent savings accounts (ISAs), with the tax-free lump sum of up to 25% of the pension being particularly valuable.
Employees who pay higher rate tax when working, and so get tax relief at the higher rate, but who pay basic-rate tax in retirement, get an even larger benefit.
Chris Curry, director at the PPI, said: “Pension tax relief offers important tax advantages, particularly to higher rate taxpayers.
“However, despite tax relief on contributions costing up to £35 billion a year after allowing for the introduction of automatic enrolment, tax relief is poorly understood and there is little evidence that it encourages pension saving among low and medium earners.
“The current system of pension tax relief favours higher and additional rate taxpayers. Even with pension saving boosted for lower earners by automatic enrolment, basic-rate taxpayers are estimated to make 50% of pension contributions, but receive only 30% of pension tax relief on contributions.
“Pension tax relief on lump sums, at an estimated cost of £4 billion a year, is similarly uneven. While only 2% of lump sums are worth £150,000 or more, they attract almost one-third of tax relief on lump sums.
“While recent reforms have reduced the cost of tax relief, they have not increased the value of saving for any individuals. More radical alternatives, such as a single rate of tax relief applied to all pension contributions, could spread the advantages of tax relief more evenly.
“A tax relief rate of 30% could have a cost similar to the current system. If presented clearly, a 30% rate could give a larger incentive to basic rate taxpayers to save, while still leaving pension saving at least tax neutral for higher rate taxpayers.
“But implementation of a single rate of tax relief would be far from straightforward, with significant changes in the administration of pension contributions required.
“The resulting tax charges could be very difficult to understand and lead to changes in behaviour by employees and employers.”