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This is no time for TEE: four reasons to resist turning pensions into ISAs
Former Treasury minister David Gauke has been appointed Secretary of State for Work and Pensions.
This has prompted speculation that he might bring with him an apparent enthusiasm within parts of the Treasury, and certainly some right-wing think tanks, for converting the current pension regime into one resembling ISAs.
At the moment the contributions you make to a pension during your working life are made tax-free, they build up tax-free, and you pay tax on them when you come to take your pension (this is known as exempt-exempt-taxed or EET). There is also tax relief for employer contributions. With an ISA, there is no upfront tax relief but no tax is paid when the money is withdrawn (taxed-exempt-exempt or TEE).
But there are a number of good reasons why a move to an ISA-style pension regime should be eschewed:
How many savers will believe that the promise of tax-free income many decades into the future will still stand when they get there?
Ending tax relief on pension contributions is potentially attractive to government, because they receive a short-term boost to state coffers. So a pure TEE system could lead to an initial annual £17 billion net windfall to the government, as tax is still collected on virtually all pensions in payment, but without the cost of tax relief on contributions.
The price is lower tax revenues for future governments. Also, having a generation of pensioners completely exempt from income tax, and therefore bearing little of the burden of ongoing state expenditure, is unlikely to be politically sustainable.
2: Undermining pension saving
Up-front tax relief is currently provided on pension savings for several reasons:
- To avoid people being taxed twice on the same earnings, both before and after it goes into a pension.
- As a form of incentive to save, although there is a strong case that many savers are unaware that they receive it.
- To bolster the savings pots of pension scheme members.
- To send a strong signal that the government believes pension saving is important.
The Treasury has already taken tentative steps towards adding ISAs to the retirement savings mix. In April it launched the Lifetime ISA, a messy hybrid savings account for the under-40s for saving for either a home or old age. But there is little sign that this will attract new savings nor will be used primarily for retirement saving.
So there is a risk that bringing pensions into the ISA regime undermines long-term saving. People are used to dipping into ISAs when they like. So the government will be under pressure to let people use retirement savings early. Yet, we know that savings levels are too low. And employer support for saving could be undermined if the money doesn’t go towards retirement.
In workplace pensions, most money goes into default funds invested in a range of long-term financial assets. But some 80 per cent of ISAs are held in cash. This would be a terrible investment decision for savings that require real returns over several decades.
The ISA system also reinforces the deeply inefficient personal pension system of millions of individual accounts.
Taxing withdrawals acts as an incentive to stage payments over time to minimise the tax bill. This brake would be absent with TEE, increasing the risk that people could run out of money early in their retirement.
One of the purported advantages of an ISA-style pension system is that it would be simple and predictable.
Yet, it is hard to see that an ISA-style system would work for defined benefit schemes, which pay a pension based on salary and service. If the tax on accrual were paid by the individual, individuals would see an immediate drop in take home pay, at a time when real wage growth is virtually non-existent. If the scheme paid the tax, it would face greater administrative burdens. Also, DB benefits are only paid if an individual meets certain conditions (usually, being still alive) at a particular date in the future. So currently members pay income tax on the benefits they actually receive. Under an ISA approach, they are taxed on a benefit they might never receive and without any regard to how long the benefit is paid.
To counter this, would you then have different tax regimes for different types of pension?
And how would existing pension savings that have already received tax relief be treated? Would savers face a windfall tax? Would current savers have to cope with a mix of taxed and untaxed pension payments?
Simple it is not. Would a government with other priorities, in particular leaving the European Union and clinging on to power, be able to undertake such a complex and contentious change?
4: Saver protection
Workplace pensions have established systems of governance. At its strongest, trust-based pensions are operated with trustees, some nominated by employers, others by employees, to run things in the interests of members.
Even insurance company pensions have to be overseen by independent governance committees. Although these are limited in power and, ironically, in independence, they do provide some level of oversight.
But no such regime exists with ISAs.
Likewise ISAs lack the other consumer protections that pensions have. Charge caps on default funds for workplace pensions make it less likely savers are ripped off by inflated charges.
When it comes to workplace pensions saving, there are many challenges to be tackled: low levels of provision, insufficient coverage and an inefficient system. None of those would be solved by trying to convert pensions into ISAs.