2 February 2016
The Chancellor has many important decisions to make next month, but one stands out for its impact on people's financial security in retirement and on future generations - how to reform pension tax relief. All the signs are that he has not yet made up his mind.
The current system of providing pensions tax relief at people’s marginal rate of income tax is ripe for reform. It is very poorly understood. And right now, someone earning £26,000 putting away £1,000 a year into their pension will only get a £250 top-up from the Government, while someone earning £50,000 putting away the same amount would get over £650. So even though it’s harder to save when you earn less, you get less Government help than a higher earner. That just can’t be fair. Even worse, the vast majority of higher-rate taxpayers pay basic-rate tax in retirement, thereby benefiting from an extra helping of state generosity. The current system truly works on the basis of giving more to those who already have plenty.
Contrast that with the DWP's forecasts for future pension income. Even with auto-enrolment completed, it estimates that the vast majority of under savers will be people in the income bracket between £22,000 and £52,000 - the very people who arguably get short-changed by the current set up.
Fundamental review
The ABI has been campaigning for a fundamental review of the pension tax relief system for the last three years. So we were delighted about the Chancellor's consultation over the summer.
To ensure our analysis of the options was top-notch and evidence-based, we commissioned the Pensions Policy Institute to analyse how individuals would be affected by different options. We also commissioned the National Institute of Economic and Social Research to run the Pensions ISA idea through their macro-economic model.
On the basis of our work, we believe the Chancellor should rule out a Pension ISA. It is superficially attractive because ISAs are well understood and have been a success. More to the point, in theory it could raise considerable sums for the Exchequer which must be an enormous temptation given the fiscal climate. The extent of the savings of course depends on how much of an upfront Government contribution is made available.
But a Pension ISA would not deliver on the Chancellor’s key reform principles.
Most fundamentally, it would not incentivise savings. Research has shown that in a Pensions ISA world, employers would expect employees to value salary more than pension contributions, and to save less. Many employers would also reconsider how much they contribute to the pensions of their employees.
Nor would a Pension ISA encourage personal responsibility. Our consumer survey shows that less than one in five trust future Governments to leave their pension savings untouched – wholly rational given no Government can bind future Governments, and the promise that people won’t be taxed when they access their pension can be decades away. It could be not jam tomorrow, but jam in thirty years! But most importantly, analysis shows that the macro-economic implications of moving to a Pensions ISA would be significant – this move would depress GDP, savings, productivity and wages. This is because a Pensions ISA system moves the tax burden away from pensioners and onto the working age population.
We know from the OBR’s forecasts that the proportion of GDP spent on health, state pensions and long term care costs will increase by 40% over the next 50 years because of the large increase in the population over 65. Shifting the tax burden for these costs wholly to younger generations would be unfair – young people are already struggling to get on the housing ladder, real wage growth is depressed and employment is less secure.
Some, like David Willets, argue that even as things stand at the moment, the baby boomers have been guilty of a failure to protect the interests of future generations. But moving to a Pensions ISA system would really be like trashing the house and leaving the younger generation to clear up.
Savers' Bonus
Instead of moving to a Pensions ISA, we are advocating a Savers’ Bonus. This would be a single rate of tax relief for all. We believe this would be a genuinely radical reform that would stand the test of time. A Savers’ Bonus will be much easier to communicate than the current system, ensuring people understand the benefit of saving into a pension. It will also exploit people’s loss aversion – people will save so as not to miss out.
A single rate, presented as a Savers’ Bonus, also better targets Government spending towards those most at risk of undersaving. A single rate would move us from a split of 70:30 of tax relief in favour of higher-rate taxpayers to a split of 50:50 between basic-rate and higher-rate taxpayers.
It would be a fair deal for all. Those who do the right thing and save for their retirement would get the same top-up from Government no matter how much they earn.
And a single rate will retain the incentive to save for all but the very few who have retirement savings well in excess of the Lifetime Allowance – and those people are usually well advised to organise their financial affairs in the most tax-efficient way.
Finally, a single rate Savers Bonus would be sustainable for the long term. Depending on where the rate is set, it will allow the Chancellor to make sustainable savings. And, by keeping pensioners as taxpayers, we won’t shift the responsibility of funding an ageing society wholly on the working-age population.
Conclusion
So, in conclusion - the system desperately needs fundamental reform to encourage a savings culture. But a Pensions ISA would be wrong-headed because it will cause long-term damage to our economy. We believe the Savers’ Bonus is the right way to go about this.
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Hear more on this issue at the ABI's Transforming Long-Term Savings Conference on 19 April 2016.