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How big was Gordon Brown’s raid on pensions?

Nigel Williams, 3 October 2011

When people mention personal pensions, Gordon Brown and the Dividend Tax Credit get mentioned soon afterwards. This note takes a look at how big an effect that change in taxation had on individual pensions.

A study in published in 2000 by the Institute for Fiscal Studies provided a method for answering the question by looking  at the related matter of the smaller 10% tax credit on dividends in ISAs. It made the point that stronger growth, from which pension funds would benefit, also increased the amounts lost to the change in taxation. Borrowing from their methods, I offer an estimate of the damage done to pension funds by the Chancellor’s decision in 1997, when the credit was 20 per cent.

A 20 per cent tax credit means that a dividend of a pound will be worth £1.25 to the recipient. The IFS envisaged that half of growth would be paid as dividends and half received as capital growth. That may have changed slightly as a result of the tax changes. Extra tax on dividends may encourage companies, especially those with pension-fund shareholders, to use the potential dividend money for re-investment. The pension fund gets the value as capital growth instead, with potential for tax allowances there. Since the ultimate aim of most companies is to get money out of them, little change in dividend behaviour was expected.

The rationale for pensions tax relief is that the same money should not be taxed twice. An employee foregoing part of a salary will pay tax on it when receiving a pension, but gets relief at the time the salary is first paid. In fact, a portion, currently a quarter, may be received as a lump sum without further tax. IFS regarded this as equivalent to a substantial dividend tax credit, amounting to over 10 per cent of the fund value. As for the tax credits themselves, they applied to taxable profits. A company paying a dividend would pay corporation tax on its profits. Dividends would come out of these profits, so they could be regarded as net of tax. The tax credit restored them to the gross amount. Again, when the pension started paying out, income tax rules would apply and tax would be paid on the proceeds from those dividends.

Savers are already used to seeing tax paid twice on an investment. They pay income tax as they acquire the capital in salary, then they pay more income tax on the interest earned by investing the capital. In a sense the dividend tax credit was relief from the equivalent of income tax on interest. Without the credit, investing the money is subjecting the savings to further taxation. There is a case for letting people off in return for planning sagely for retirement, but a similar case applies to day-to-day savings.

The important question is how much Gordon Brown’s decision cost. In reply, I begin by listing assumptions and parameters:

  • Tax relief was 20 per cent.
  • The credit was abolished in 1997.
  • An estimated half of fund’s growth was paid in dividends (often reinvested), not as accumulated capital.
  • Typical growth in a pension fund was slightly below 5 per cent per year.

Each year since, a quarter of the dividend-related half of the companies’ growth, which would have attracted a tax credit, received no such credit. If companies are losing money, then the loss to investors is likely to appear all in the capital, without any dividend. This may mean that a 50 per cent pay-out ratio is too small, but only in a few of the relevant years.

The total cost is the compound multiplication of one eighth of the fund’s growth over the period. Morris and Palmer quickly pass from mentioning Gordon Brown’s raid to describing annual charges of 1½ per cent. 1½ per cent each year is equivalent to a tax credit on dividends of 6 per cent, itself constituting half of growth of 12 per cent. Charges on that scale are clearly greater than the tax on growth below 5 per cent each year.

Figures made available by TrustNet for pension fund growth give just over 2000 funds operating ten years or more, with median growth since 2001 of 53 to 54 per cent. Allowing for compound interest and the fact that the money is paid into the fund in regular instalments, the loss to private investors amounts to 0.485 per cent of the gross fund each year. Since the change was made, the accumulated difference by now, 2011, would be around 4 per cent of the fund value. Over the course of the whole plan, that would grow to 12 per cent.

That, then,  is the short answer:

  • approximately 4 per cent of the fund since 1997;
  • potentially 12 per cent over the course of a whole plan.

Defined benefit funds would have to make that up for their savers, whereas defined contribution investors would choose between higher contributions and lower incomes. Obviously, there is a lot of potential for variation. Funds receiving greater or lesser dividends will lose more or less in tax.

By the standards of some of the losses reported in “You’re On Your Own”, 12 per cent of retirement income is not a huge loss. Table 3 on page 39 and figure 4 on page 40 show some of the others, affecting defined contribution schemes especially. Adding a tax credit line of 12 per cent would bring the overall reduction in table 3, where all the reductions have been multiplied together, to 77 per cent. Gordon Brown’s change hit defined contribution and defined benefit schemes alike, but served to highlight the difference in the two types of schemes. Where employers ran defined benefit schemes, they could respond to the need to make more contributions either by paying up or by reducing the availability of such schemes. Where personal savers were offered only defined contribution schemes, their response to lower returns was often to save less, cutting their charges but cutting their returns as well. The full consequences of that response are set out in the book.

This is the second part of a short series on personal pensions.

2 comments on “How big was Gordon Brown’s raid on pensions?”

  1. “Gordon Brown’s change hit defined contribution and defined benefit schemes alike”

    Not strictly true. It affected FUNDED defined contribution and defined benefit schemes alike.

    Of course, many (in fact most, other than the Local Government scheme) public sector schemes aren’t backed by investment funds at all – they are paid from a combination of current contributions and taxation. These weren’t affected by Gordon Brown’s tax raid.

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