Government's mini budget 2022

This morning, Kwasi Kwarteng, Chancellor of the Exchequer, unveiled plans for 2022 in his very first mini budget.

Part of his strategy is to cut the basic income tax to 19% in 2023. But is this a double-edged sword? What will happen to a taxpayers' pensions? James Jones-Tinsley, Self-Invested Technical Specialist at BW, believes individuals will need to increase their personal contributions.

James Jones-Tinsley, Self-Invested Technical Specialist at BW, said: "For consumers, the cut in income tax to 19% is a double-edged sword. It is an immediate gain in income with a long-term sting in the tail from a smaller pension. The one percent loss may sound inconsequential, but it compounds over a working lifetime – as Einstein said, it's 'the eighth wonder of the world' and those who don't understand it, pay the price."

"Individuals now need to increase their personal contributions just to stand still. This might not be a tempting prospect with climbing interest rates and rising inflation. Nothing in the Chancellor's speech spoke to the UK's looming retirement crisis – there's only so long the Government can kick this can down the road.

"Our calculations show that a 40-year-old basic rate tax payer earning £37,500 pa and contributing 12% of their net pay to a DC pension is likely to find their fund will be £5,700 lower as a result of the reduction in tax relief (equivalent to a reduction in ‘income in retirement’ of £360 per year*):

"For someone just entering the workforce and starting to save into their pension scheme – say someone age 22 paying in 12% in a net pay arrangement – the impact on their fund will be a hit of around £30,000, equivalent to £1,900 lost income each year in retirement. Were they only to be paying in 8%, that would fall to a £20,000 lower fund; that’s £1,250 less a year in retirement."

Alongside these changes, this morning's mini budget also had a seismic impact on gilts. Ian Mills, Partner at BW, described the impact as an allergic reaction, saying:

“So far today, the gilt market has reacted with what could best be described as an allergic reaction. 20-year gilt yields were up 0.4% pa shortly after the Chancellor’s announcement, reflecting increasing expected future supply of gilts, combined with fears that the tax cuts will add further fuel to the inflationary fire. This adds to rises in yields yesterday caused by the Bank of England’s policy announcements. The impact in other markets has been less profound: Sterling has maintained its recent downward trend, now trading below $1.12 for the first time in decades; and the FTSE100 fell – down about 1.6% in the first hour or so.

“The effect of these rising gilt yields will be significant – DB pension scheme liabilities will have fallen sharply in just a couple of days, perhaps by as much as 10% for some schemes. Many schemes will find that their funding positions have improved sharply, particularly those that have not fully hedged their interest rate and inflation risks with LDI. For many this will present opportunities to de-risk, perhaps accelerating existing de-risking plans. Some schemes that previously thought buy-out was a long way off may now find it is within easy touching distance. Trustees should review their funding positions in the next few days and assess the implications for their own specific circumstances.

“Whilst these falls in DB pension liabilities may be good news for some scheme’s solvency positions they will cause significant challenges, especially for schemes with LDI portfolios.

“DB schemes using LDI will come under pressure, especially if the rise in yields is sustained. The rise in gilt yields will likely cause schemes to have to recapitalise hedges – some will be able to do so from cash reserves but others will find they are forced to sell other assets. Some schemes could even be forced to unwind hedges exposing them to the risk of reversals in yields. Schemes using LDI should immediately review whether their collateral buffers remain adequate, and consider taking remedial action if not. Waiting to receive a collateral call that you cannot meet is not a good idea.

“Schemes with LDI portfolios alongside substantial illiquid asset programmes (e.g. private equity, real estate, private credit) may find that their illiquid asset base is now a much more significant proportion of their overall portfolio than they ever planned it to be, as liquid assets will be the natural first port of call to maintain LDI hedges. As well as causing problems in meeting LDI collateral calls, the rise in yields could disturb the ongoing viability of the whole strategy. It may now be much harder to maintain a suitably diversified portfolio or even to meet benefit payments in extreme cases. These schemes should immediately review their illiquid asset programmes to ensure they remain suitably robust to the possibility of further rises in gilt yields.”

Notes

1. *Assumes 6%pa return on investment, 3% salary growth, unchanged annuity rates over 20 years, and a non-increasing pension in retirement with no guarantees or attaching widow's pension

2. Only works for basic rate taxpayer. Higher rate payers get relief at marginal rate

3. See https://www.gov.uk/guidance/rates-and-thresholds-for-employers-2022-to-2023#paye-tax-and-class-1-national-insurance-contributions