What is a bird-in-the-bush worth to pension savers?
It’s a hard sale to make.
“See that bird in your hand? Well I am taking it away. But don’t worry – in 50 years time you will get two, actually make that one, pecking around over there in the bush.”
This is the scenario the Treasury is effectively exploring with its consultation on changing the pension tax regime.
At the moment the contributions you make to a pension during your working life are made tax-free, and you pay tax on them when you come to take your pension. There is also tax relief for employer contributions.
The principle is to avoid people being taxed twice on the same income and to encourage pension saving.
The government is now to consider stopping tax relief on contributions to a pension and instead allow payments made from them to be made tax-free, much like an ISA today.
Proper scrutiny of the £50 billion system of pensions tax relief is certainly long overdue.
A strong case can be made that the current set-up is poorly targeted, ill-understood and has been the victim of tinkering by successive governments more concerned with filling a Budget hole than developing a coherent savings strategy.
So the Treasury is right to give a difficult and potentially highly controversial issue its attention. It is particularly welcome that, after the shambles that resulted from the rushing in of so-called pensions freedom, that it is exploring the topic through a Green Paper.
This should give plenty of time for consideration of the evidence, widespread consultation and – an approach that has fallen out of favour in recent years – perhaps even the establishment of consensus so that any reform is long-lasting.
The case against the existing system is compelling. In 2012/13, people with incomes of more than £50,000 accounted for 10 per cent of income tax payers but nearly half of private pension contributions attracting tax relief.
The 304,000 people who earn £150,0000 a year or more comprise one per cent of tax payers but received £3 billion a year in relief.
Among the biggest beneficiaries are those who receive tax relief at a higher rate than they pay in retirement, for instance going from the higher rate income tax band to being basic rate tax payers when they draw their pension.
It is also not at all clear that the system is sufficiently well understood that it acts as an effective incentive to save.
The Treasury’s Strengthening the Incentive to Save document notes the ISA-style reform favoured by right-wing policy wonks. This does have some progressive merits such as removing the 25 per cent tax-free lump sum from the system. Currently this is a massive advantage for the richest savers. For while two per cent of lump sums are worth £150,000 or more, they attract 32 per cent of tax relief on lump sums.
But the paper does not mention other approaches that deserve very serious consideration, most notably the idea of a single rate of up-front tax relief, set at say 30 per cent or 33 per cent, that would be of particular benefit to those low and middle earners who are ill-served by the current system.
There are a number of reasons to be wary of ISA-style pensions.
For a start there is a risk we might expect too much of them. The government has a poor track record in this regard. Treasury is correct to be concerned about the levels of contributions going into defined contribution schemes – though it gives scant consideration to the massive fall in employer contributions at companies that scrapped defined benefit schemes. But, just as pensions freedom didn’t solve problems with the retirement income market, we should not expect incentives to do the heavy lifting on improving contribution rates. The best way to do this is by setting a long-term plan for raising minimum contribution rates for automatic-enrolment pensions.
One of the criteria set out by the government is for any new system to be simple and predictable. Yet, it is hard to see that an ISA-style system would work for defined benefit schemes. Would you then have different tax regimes for different types of pension?
Likewise, how would existing pension savings, that have already received tax relief be treated? Would current savers have to cope with a mix of pension payments, some of which were tax exempt and others which are not. Simple it is not.
Strangely the thorny issue of salary sacrifice, which helps firms reduce their employment taxes (and potentially cut some other pay-related benefits), is also not mentioned in the Treasury consultation. However, in the separate Budget report the government says it will “actively monitor” their growth.
Once pension savings appear to be the same as other forms of saving it would be easy to undermine their role in providing for people’s old age. It would be tempting for future governments to allow people to dip into these savings for purposes such as house purchases, leaving less for their retirement. We could also lose the strong governance arrangements in many existing pension schemes which are not-for-profit and overseen by trustees who have a duty to act in savers’ interests.
There is also the risk that the promise of tax relief on pension payments may be watered down over coming years as future governments seek funds for other projects. This will do nothing to improve trust in the pensions system.
It is easy to see why any government would prefer to save the £50 billion in gross tax reliefs incurred each year in the knowledge that future administrations will have to deal with the reduced revenues of future years when the pensions go into payment.
“Bird. What bird?”