Pension and Isa worlds should merge
The pension and Isa worlds should merge to create a common tax framework, with fluidity of assets between both sectors, says Michael Johnson, author of a new reform paper. He talks to Gregor Watt
Just under two months into the coalition Government’s term of office and a number of pension policy decisions have already been taken. The Government is to scrap the default retirement age, accelerate the state pension age increase and “triple-lock” the basic state pension. It has also torn up Labour’s complex proposed restrictions to higher-rate pension tax relief in favour of a reduction in the annual allowance and confirmed that compulsory annuitisation will be scrapped next year. But many in the industry are hoping this will just be the start of a more fundamental reform of the long-term savings landscape.
The publication of a new research paper from the Centre of Policy Studies has come at an opportune time to stimulate discussion about introducing more wholesale changes.
The report, called Simplification Is The Key: Stimulating And Unlocking Long-Term Saving, puts forward several innovative proposals on how to address some of the many problems facing retirement saving.
Michael Johnson, the report’s author and a former Secretary to the Conservative Party’s Economic Competitiveness Policy Group, says the issues around long-term saving and retirement income should not be underestimated.
Johnson says: “It is one of the three elephants in the room. We have got climate change, we have got the Budget deficit and then, linked to that, we have got the whole question of pensions.”
The report sets out the familiar tale of the shortcomings of our current pension system. Anyone working in pensions will be familiar with the statistics that form the background to the report; the sharp increase in the proportion of the UK’s population over 65, the decline in occupational pension saving and the decline in the household savings rate over much of the last decade. In addition, there is the increase in cost to the state of providing either pension income or benefits to the growing pensioner population.
’We have got climate change, we have got the Budget deficit andthen, linked to that, we have got the question of pensions’
All the figures point to one thing - a greater need for individual retirement savings.
But as the report states simply in its introduction: “Reference to ’the pension crisis’ is not so much a reference to today’s pensioners as today’s workers, when we come to retire. Unless retirement age is pushed back much further than currently planned, the alternative is an increasing tax burden on the future working population. It seems inevitable that today’s workers will have to rely more on sources of income other than a pension (state or otherwise) but savings levels are simply too low to meet their retirement income expectations.”
But pensions are not a popular savings vehicle in their current form due to “attitudinal, behavioral, informational and structural barriers” all combining to put people off saving for their future. Furthermore, they do not trust the industry.
In fact, Johnson says the word pension is part of the problem as large sections of the public are disillusioned with the whole pension saving concept and the word itself no longer describes the way people will have to fund their retirement.
“It is absolutely outdated. We have to wean our-selves away from this idea that there are some clear-cut cut-off points in life where one stops working and starts receiving what we currently call a pension. It is not sustainable for all the reasons that are in the public domain.”
Regardless of the language used to describe the problem, Johnson says the structure of the current saving system has to be changed to make it work properly.
He has come to the conclusion that the starting point has to be to simplify the rules surrounding long-term savings, in particular, to try and get rid of the distinction between Isas and pensions.
Johnson says: “If I was to try and prioritise what the paper is saying, it is that we currently have two disparate worlds, one called pension, one called Isa. That in itself starts the complexity ball rolling. They are taxed differently, you can’t readily compare particular products, particularly within the context of pensions - anything that has got life insurance in it is insanely complicated.
’You are starting to break down the barrier or schism between the two worlds’
“So, the main tenet of the paper is to suggest ultimately a merger of the Isa and pension models and that means a common tax framework.
But that is a medium to long-term vision. The question is, how do we get there? I think the starting point is to introduce what I describe as fluidity of assets between the pension and Isa worlds.”
This fluidity would allow savers to convert Isa-type savings into pensions more easily or allow access to some pension assets before retirement to help overcome some of the reluctance to save.
Johnson says: “Deciding to save is a big decision but currently an immediate second decision is then required. Should I take the bribe that is tax relief and forgo access to assets potentially for 30 or 40 years or do I go for ready access in an Isa-type world and obviously forgo the tax relief? What I am trying to do is to delay the need to make that second decision without subsequently being penalised. I am suggesting that we bring the Isa and pension worlds together. If you take the first example where you have gone down the Isa route, I am now suggesting that, actually, when you get to retirement, you can look at your Isa assets and get retrospective tax relief if you move those Isa assets into the pension world. So you are starting to break down the barrier or schism between the two worlds.
“Equally, if you went down the other route, that of pension saving, I am suggesting that, like many others, the Treasury should be indifferent as to whether the 25 per cent lump sum is taken at retirement or earlier. It is indifferent because this cash is tax-free.”
By being able to blur or remove the distinction between savings wrappers, Johnson says the savings industry would benefit from the simple truth that savers like Isas and many don’t particularly like pensions.
“I am saying let’s recognise reality. People like Isas, people hate pensions. The evidence? Last year, £37bn went into Isas. Last year, £24.9bn went into pensions from employees. Not only is 37 a bigger number than 24 but the 24 was bribed with tax relief. Recognise the reality, Isas are very popular.”
Johnson suggests that removing the distinction between types of saving should be accompanied by reform of the limits on the two different types of saving. There should simply be one Isa regime. Rather than cash or stocks and shares, there should simply be Isa saving. He also suggests that the £10,200 limit on Isa saving should also be removed and the limits for pension saving should also be radically altered and simplified with the current annual contribution level of 100 per cent of earnings up to £255,000 and the lifetime limit both scrapped.
Instead, the two sets of rules should be removed and replaced by a maximum annual limit of £45,000 for all tax incentivised saving (excluding the EIS and VCT schemes) of which up to £35,000 can be pension savings.
These numbers have not been plucked randomly out of the air. Johnson, a former investment banker, has spent the best part of five years looking at the problems with the UK pension system. He says that the £35,000-£45,000 limits represent cost break-even from the Treasury’s perspective, that is, the future cost of tax relief would be roughly the same as what it will be under the current framework of tax relief and contributions limits.
’The commonsense place to get to in terms ofa harmonised tax structure is 20 per cent relief up front for everybody’
Since the publication of his report, the Government has moved some way down the road to simplification by scrapping the previous administration’s proposed restrictions to higher-rate pension tax relief in favour of restricting the annual allowance to between £30,000 and £45,000.
Johnson says as his calculations show the £45,000 level is a break-even point from a tax relief cost perspective, Chancellor George Osborne has left himself room to make significant tax relief savings.
As an industry outsider with no vested interests, and keen to depoliticise the pension challenge, Johnson consulted widely to formulate his proposals for the paper. In fact, he says a lot of the paper wrote itself, with Johnson merely responsible for putting the words in the right order.
The financial modelling, done by pensions consultants Hewitt, contributed significantly to the calculations on what level tax relief should be set at.
Significantly, the proposed new annual limits would include tax relief at a savers’ marginal rate.
He says: “Based upon the existing framework of contributions made to pensions across the income spectrum, we projected forward the consequences for the Treasury of introducing different annual con-tribution limits. As one of the graphs shows in the paper, the £45,000-£35,000 number represents roughly tax relief break-even. Note that this is at the savers’ full marginal rate of tax relief so that 40 and 50 per cent taxpayers would be able to receive some tax relief at their full marginal rate but only up to the £35,000 contribution limit.
“If that number were £60,000 rather than £35,000, then the tax relief cost to the Treasury would soar. Equally, if it were £20,000 rather than £35,000, it would diminish, so we are introducing a tool for the Government to control tax relief expenditure within the current framework of how tax relief works.”
But Johnson says these changes should be seen as merely a stepping stone to the real goal of harmonising the tax regimes of the two forms of saving.
The tax incentives for Isa and pension saving are currently at odds with each other, with pensions attracting tax relief on contributions but taxed on income (that is, EET) and Isa contributions sub-ject to income tax but any funds withdrawn currently free from income tax (i.e. TEE).
In a proposal that should attract much interest from a Government needing to find considerable savings, Johnson suggests that by introducing a harmonised tax system for both pensions and Isa and adopting the Isa model which offers no upfront tax relief, the annual cost to the Treasury would be reduced by £8.5bn.
He concedes that this does remove some of the incentive for saving so, as a compromise, he suggests a half-way house whereby tax relief could be capped at 20 per cent up front and retirement income would also be taxed but limited to 20 per cent as a way of ret-aining some incentive for higherand additional-rate taxpayers.
“I think the common-sense place to get to in terms of a harmonised tax structure is 20 per cent relief up front for everybody, so you can call that front E 20 or T 20, depending on which way you want to spin it, middle E as before and then at the back end you can call it E 20 or T 20, but I am suggesting that all income in retirement, irrespective of your income tax marginal rate, is 20 per cent.” These proposals would save the Government £5.6bn a year.
Johnson admits that the idea of limiting income tax in retirement could be seen as a sop to higher-rate payers but says this is the price of retaining some incentive for higher earners to commit to this system.
“If we are limiting upfront relief to 20 per cent and the saver is a 40 per cent taxpayer while work-ing, then he is likely to ignore the pension world, especially if he thinks that in retirement he may remain a higher-rate taxpayer. But if 40 per cent or 50 per cent taxpayers today know that when they retire they will only be paying 20 per cent, then that is a fairer proposition.”
Johnson’s paper has not just concentrated on tax relief and access to pension savings. Other initiatives included in his 16 proposals include allowing people to contribute to a spouse’s savings up to the full annual limit as long as there is sufficient relevant taxed income between them to support the contribution.
He also proposes that, upon death, unused pension assets should be able to be bequeathed free of IHT, on the condition that the assets remain within pension savings. This would encourage a wealth cascade down the generations and reinforce the sense of ownership of pension savings. In addition, he suggests that Isas could be included in the auto-enrolment regime due to be introduced in 2012 and says a much more radical approach to annuitisation could be adopted.
Provided that an individual has savings of at least £50,000 at age 75 or has guaranteed income of 40 per cent of the median salary from a reliable source, then they should be free from the requirement to annuitise all pension savings. But despite the methodical app-roach he has taken to addressing the problems that current beset individual long-term saving, Johnson warns that the changes he is proposing would not do any good without substantial reform of all the other pillars of pension provision.
Johnson was also the author of a separate report published by the CPS in September 2009 called, Don’t Let This Crisis Go To Waste, which looked at the state pension and Nest. He describes his new report as a sister paper and says “we should not seek to reform any of the state pension, Nest, public sector pensions, personal pensions or occupational pensions in isolation.
“This is one of the flaws of past policymaking; in practice, these separate sources of retirement income form a single ecosystem and how that interfaces with means-tested benefits requires very careful consideration.”
The CPS is shortly to publish a third Johnson report focused on public sector pensions, now highly topical following the announcement of a commission on public service pensions, to be chaired by John Hutton.
Johnson’s proposals to stimulate saving
- A contributions limit consistent with lifetime saving of £45,000 a year
- Simplify Isas
- Permit pre-retirement asset mobility from Isa into pension savings, with standard-rate tax relief
- Include Isas in employee auto-enrolment legislation
- Permit limited pre-retirement access to pensions savings
- Post-retirement, amend access to pension savings
- Annuities purchased with Isa funds should be tax-free
- Permit pension savings flexibility within couples
- Encourage wealth transfer into pension savings
- Inter-generational wealth transfer between pension savings upon death, free of inheritance tax
- Permit regular pre-retirement access to pension savings
- Encourage employers to match employees’ Isa contributions
- Introduce a Junior Isa
- Abandon arbitrary age watersheds fold the forthcoming Saving Gateway into the Isa framework
- Promote the benefits of long-term saving