In advance of the Autumn budget, I have been doing some back of the envelope calculations about the country’s finances. Suffice to say they aren’t good. Debt is too high and interest costs are only going to rise. Generationally high borrowing costs mean low cost debt will get refinanced on higher rates. I round off this week’s missive with a quick take on what the state of the country’s finances could mean for pensions, but before we get to that, let’s look at the positives.
UK plc is in a far better place. While the country runs a spiralling deficit, corporate dividends continue to increase. This looks sustainable too – with profit margins flying high those dividends represent a historically low percentage of earnings, and debt ratios are also pretty comfortable.
Most of the above can be repeated about the US, and the cherry on the cake comes from the fact that second quarter earnings across these two geographies were extremely strong. Of course there has been the odd blemish, but in the main, results have comfortably exceeded forecasts, and future forecasts have been upgraded too. The themes remain the same, with AI a major winner. Just look at Oracle, who released a simply extraordinary upgrade to longer-term guidance.
We’ve also seen several encouraging developments around the wider macro. US consumer confidence has rebounded strongly from the tariff-induced lows in the Spring. That feels a long time ago. The number of tariff-related conversations in earnings call were down 21% from Q1, with inflation down 24% and an even sharper decline (32%) in companies citing ‘uncertainty’.
With results exceeding estimates, profit forecasts rising and conversations turning distinctly more positive, it is no surprise that markets have been favourable. And that’s before we consider the impact of the Federal Reserve’s first interest rate cut of 2025 has just landed. The anticipation of further cuts has also helped markets, or from another point of view, serve to further increase valuation.
With three cuts so far in 2025, the UK rate setters have been more dovish than their colleagues across the pond. If that’s enough to generate the growth that Labour needs to shore up opinion polls remains to be seen. Growth is projected to hover either side of 1.5 percent over the next couple of years according to the Bank of England’s economists. Upwards revisions to that will be crucial if the Chancellor is going to be able to produce a budget that is at least palatable to the public. Absent that, significant giveaways aren’t really an option. The savage dismissal of Trussonomics serves as a reminder of the need to keep fiscal stability front and centre.
Pinning down the size of that challenge is hard. Current estimates for what Fleet Street are apparently contractually obliged to call a ‘black hole in the public purse’ range up to £50bn. That’s a figure Downing Street has distanced itself from, but there is little doubt that without an upwards inflection in growth numbers, the government needs to find savings somewhere. One option is to look at pension reform.
Scrapping the 25% tax-free lump sum has been mooted. While £18.08bn of tax-free cash was taken out last year, 2023/4 saw only £11.25bn taken. If we average those figures out and apply a tax rate of between 20% and 40%, the government would raise between £3bn and £6bn by scrapping it. I would personally be surprised if Starmer was willing to enrage a key demographic for a reward that small.
Another option would be to look at tax relief on contributions. This ticks a lot more of Labour’s boxes.
The net cost of pension tax relief was £52.5bn in 2023/4. The cost will have increased in 2024/5. We’ve seen pay increases of around 5%, which have a stronger impact for pension tax relief costs as the freezing of allowances take more people into the more costly higher rate band. But for simplicity, let’s conservatively assume the cost of relief rose to around £55bn last year. Because of the tiered rates available, the majority of the money benefits higher and additional rate taxpayers. It must have crossed the government’s mind to standardise the relief at 25%.
Not only would that simplify the system, it would raise about £10bn, before any behavioural changes are factored in. It would not be popular with everyone, but those basic rate taxpayers would be better off. This group comfortably outnumbers higher and additional rate contributors, and are traditionally more likely to vote Labour. Giving them a greater incentive to contribute into pensions would therefore not only help close the pension wealth chasm, it would be politically appealing, and crucially help plug the aforementioned ‘black hole’.
Of course, I have no more insight than you do on what the chancellor will do. But the fiscal predicament the government is in means it is not unreasonable to think changes to UK pension rules are not implausible.
George Salmon – Senior Investment Analyst
FPC25522
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