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Why Unfair Pensions Need Change
Posted by robin in Financial Articles Friday November 20, 2009 5:45 pm
Can you live off £95.25 a week?
Yes…no..?
Some people do. That’s the state pension this year for a single person.
Of course, you might not get that much…
That’s the ‘full’ state pension assuming you’ve paid your dues over a working life. Those retiring from April 2010 will need 30 ‘qualifying’ years’ National Insurance contributions, before then it’s more.
The equivalent in Ireland is more than double that, at current rate of exchange over £200 a week. Granted there might be a sustainability issue there given the current parlous state of government finances.
But this is not an envious gripe about the international ranking of British welfare benefits. It’s about the long-term problem of financial provision if we’re increasingly going to last into our 80s, 90s and maybe beyond.
It’s also about a virtue the British are supposed to be known for…fairness.
A system “not fit for purpose”
And fairness is what Aviva have been talking about in its call for change.
“The current pension system is not fit for purpose and is in desperate need of radical overhaul,” says its pension head, Paul Goodwin.
Working lives have changed radically and the current system is not up to the task. Ditch “flawed” Pension Credits and up the state pension upped to £130 per week they say. Give early access to pension fund cash and grant a single flat rate of pension contribution relief to 30% for all.
All progressive stuff but the most contentious one in is flat rate tax relief on contributions.
Presently the system works like this…
Personal pension contributions are paid net of basic rate at 20%. You pay £80 the insurance company collects £20 from the revenue to make a £100 contribution. Higher rate taxpayers reclaim the balance through payroll or a tax return.
Still there? Good, because Aviva argue a flat rate 30% would be both fairer and tax neutral. Mmm, there’s a thought…a fairer tax incentive to all savers? Should it be..? Would it be..?
No it wouldn’t counters L&G pensions head, Adrian Boulding from the pages of trade mag Professional Adviser:
“Beware the siren cries of those advocating a new uniform rate of tax relief for all savers… Behind the banner of ‘fairness’ lies an attack on savings which will reduce the total amount our nation sets aside for its future retirement.”
It would reduce total retirement savings..? But what would we find if we were to explore how that “total amount” is made up? Would it perchance reveal the minority account for the bulk of retirement savings? Would it reveal, that the affluent few have not been shy in plundering 40% tax relief to fill substantial pension pots?
According to government figures quoted in the Financial Times, the top 1.5% earning in excess of £150,000 a year account for nearly a quarter of total pension tax relief. In 2007/8 tax relief on contributions cost £23.3bn, nearly double what it cost in 2000/1, under the old regime.
There’s a case for greater democracy here. A successful private saving culture should surely aspire to the majority saving reasonable sums rather than a minority socking away vast amounts, generously subsidised from the taxpayer’s pocket?
The maximum permissible pension pot this year is £1.75m. Contrast that to the average pension pot used to buy an annuity in 2008 - a little over £25,000. That might buy a single person at 65 say around £30pw in income for life. The trivial sum makes the state pension look generous in comparison. Add to that the fact most annuities will remain unchanged and see their purchasing power dwindle with inflation over time.
Time to level the playing field?
Old socialists despair that after 12 years of New Labour, income inequality is wider than when they arrived in 1997. Initiatives like pensions’ simplification in 2005, dubbed “A Day” helped tip the redistributive scales. It vastly increased the amount of cash that could be stuffed into a pension plan in a single year - up to a quarter of a million quid…with full marginal rate tax relief to boot.
High earners were best positioned to take advantage. It seems they did. The government has made a move suggesting the updated regime has been suitably plundered. Finance Act 2009 capped higher rate pension tax relief for the biggest earners. Those on more than £150k face new restrictions. From April 2010 the amount they can put into a pension and claim full tax relief is being crimped. All in, it’s limp-wristed and timorous change from a government in its death spasm and a long way from fair.
Why should a £100 pension contribution cost £80 to someone on £20,000 a year but only £60 to someone on £60,000 a year, or even perhaps £50 from next April? Doesn’t the 85% of the working population paying basic rate tax need at least as much encouragement to save than the 15% who are best placed and more predisposed to do so?
The answer presumably centres on the notion of an equitable matching between tax incentives and the marginal rate paid. Higher earners pay more into the system they should be able to take more out. To grant a 40% taxpayer, a 30% relief on a pension premium is too low and a for a 20% taxpayer it’s too high.
But often lower earners take little out and high earners pay a lot less than 40%. Many a high income earner has made a mockery of the notional 40% tax rate over the years. After filling their boots with assorted tax sheltered schemes - enterprise zone development, film partnerships, venture capital trusts, enterprise investment schemes and pensions plans to name a few – and having benefits from capital gains tax being cut from a maximum 40% to a flat 18%, they have sometimes been known to wind up paying less tax than their secretaries.
Your biggest and frequently most high profile income hitters will, of course, be tucked away offshore anyway well beyond the reach of HMRC.
How to get people saving…
That we are not saving enough is the chronic wail of policymakers and pension wallahs. Our national debt load has ballooned, the population is ageing, our pay-as-you-go social security is creaking and the average pension pot won’t buy more than a few cans of cheap lager at a low end supermarket.
A cheap and popular national savings regime with high take up remains the elusive goal. The National Pensions Saving Scheme coming in 2012 is the next attempt to get lower paid earners saving. Auto-enrolment in such company-based schemes is hoped to increase participation. Recent research from Axa suggests this might not be enough – they found less than 20% of people would remain enrolled in such a scheme.
If auto-enrolment is not the silver bullet perhaps an increased flat tax incentive on contributions might be.
An Irish success story…
L&G’s Boulding argues those on lower incomes just don’t have enough cash to save anything and have more pressing priorities.
Well maybe, so back to Ireland for a moment. In 2001, the government created a new scheme. They called it the Special Savings Incentive Scheme.
It was an attempt to encourage saving by offering a simple tax incentive on a five-year fixed term. Investment could be in deposit savings or stocks and shares. Gains would be taxed at 23% on gains at maturity.
For every euro saved, the government added 25 cents.
Simple…and effective too - 1.1m people bought them, many who had never saved before.
Not a bad result in a year from a population of a little north of 4m. Compare that with the UK’s stakeholder pension flop, bought by 2.7m in its first four and a half years from a population of 60m.
At the end of the term the Irish government then offered savers another deal…
We’ll waive the 23% exit tax they said, if you stuff the proceeds into a pension…plus we’ll slap on another €1 for every €3 you put in.
Granted the original scheme locked up cash for five years not 25, but the Irish have taken this success on board and a recent report from their Taxation Commission suggested structuring pension tax relief in the same way.
They recognise people actually understood the tax incentive of SSIAs and so understood why they were a good deal…ergo, they bought into it. The new idea is to introduce tax relief too at €1 for every €1.60 contributed, effectively a flat rate of 38.5%.
Back in the UK, Aviva’s research found 83% of savers don’t understand how the tax relief on pensions works. Ireland’s experience with SSIA found people bought into a simple and compelling incentive they understood. Room for a rethink with the UK system here?
And a lesson from the UK
The UK provides a recent example that demonstrates the influence of higher contribution tax relief on saving, even in a specialist investment. It also provides a precedent that tax relief contribution incentives offered do not always match marginal tax rates paid.
Venture Capital Trusts (VCTs) are publicly listed funds offered to private investors. They specialise in investing in small growing businesses that will one day become the next Google (allegedly). This is high risk so investors are encouraged with tax breaks. When they first launched in 1995, among a range of incentives was 20% off income tax.
That was ramped up to 40% from 2004 to 2006 for all taxpayers and attracted a flood of money into what are speculative and often disappointing investments. Managers moaned it attracted the wrong sort of investor ie less savvy types who didn’t know what they were doing. The universally applied 40% tax break saw £775m raised in 2005/6. The rules were then changed again and initial tax relief cut back to 30%. Investment volume then crashed back to £200m in 2006/7.
If the initial tax incentive worked for VCTs, might it not work for pensions too? A flat rate of 30% as part of the proposed national pension accounts and perhaps flexibility, with strings attached, to dip into pension pots along the way might just be the scheme that nails the problem of insufficient saving.
Higher rate taxpayers may decide this reduced incentive is no longer attractive. By definition this group is the most able to look after itself. If they then choose to buy property instead of pensions to fund retirement, it may be a loss to insurance company coffers, but would it really a loss to the Exchequer? Such a proposal however, would require attention given to the rate of taxation of pension income. A 40% (or 50%) taxpayer getting a 30% break going in but paying more than that on income coming out does not seem fair either.
A 2009 PwC report for the Department of Work & Pensions referred to the “low levels of financial capability and… poor understanding of pensions” among many people. It also drew attention to the “barriers to saving” that must be overcome.
But if the overriding goal is to encourage the broadest possible private retirement savings to ease the long term burden on the state, granting lower income earners at least as much tax incentive seems a chance worth taking. And, if Aviva are right with their calculations, at no increased cost to the taxpayer.
Ireland’s example shows that encouraging widespread saving is not the hopeless task past UK experience might suggest. A universal 30% contribution tax break, explained simply as 42p added for every £1 contributed - might just work to all our benefit.
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