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Final-salary retirement income could be cut by a third as result of proposed pensions tax changes

The Government's tax changes on pensions are set to cut final-salary retirement pots by a third, according to Towers Watson.

In a discussion paper published this last week, HM Treasury indicated the Lifetime Allowance, which caps the total amount of tax-privileged pension saving individuals are allowed, might be cut from £1.8 million to £1.5 million – the level at which it was set when first introduced in 2006.

The impact on high earners in defined-benefit schemes (such as those which provide a pension based on final salary) could be magnified because the Government will also review how the promise of an annual retirement income counts towards this cap.

Mick Calvert, a senior consultant at Towers Watson, said: "The maximum pension that can be built up in a tax-advantaged final-salary scheme could be cut from £90,000 a year to £60,000 a year. That would be the result if the Government decided that each pound of annual income was worth £25 instead of £20 at the same time as shaving £300,000 off the Lifetime Allowance."

HM Treasury says the revenue raised by reducing the Lifetime Allowance could allow it to ‘index’ the Annual Allowance from an unspecified future date, which it hints would be no earlier than 2015. The Annual Allowance caps the amount that can be saved in a tax-advantaged pension each year, and the Budget proposed reducing this from £255,000 to between £30,000 and £45,000. Without indexation, inflation would eat into the real value of the Annual Allowance, leading to further real terms cuts each year.

Calvert added: "By freezing the Annual Allowance, the Government will increase tax revenues by dragging more people into the net. It still plans to do this for a period, but the real value of the allowance may not be eroded as quickly as feared if there is some degree of indexation in the future. The deal ministers seem to be offering could be good news for high earners whose pension saving is largely ahead of them – as the new annual limits will make it difficult for them to build a £1.8 million pot in any case. It is bad news for high earners who have around £1.5 million saved already and who had hoped to save more."

Towers Watson says the issue of "transitional protection", which is supposed to avoid taxing the money people have already saved in pensions, will be a potential minefield if the Lifetime Allowance is reduced.

Calvert said: "The losers from unpicking the transitional protection offered in 2006 are high earners with defined-contribution pension savings who have recently taken a hit from falling stock markets. Under the old rules, they could have restored their pension savings tax-efficiently by making higher contributions. That may no longer be an option. Registering for protection was far from straightforward. They may now need to repeat this process and still end up with less protection than they thought they had in 2006.

"With allowances at the level suggested, many high earners will need to revisit their retirement planning strategy and must do so very quickly. With the draft legislation not due to be published until the autumn, this will place significant demands on employers and pension schemes to communicate the tax changes and any benefit options to members so they can make appropriate choices before the new rules take effect on 6 April 2011".