There was an audible sigh of relief from the industry after the Autumn Statement, as we made it through without any fundamental reform of pension rules.
Aside from the state pension, the only other mention of note was that the Chancellor will align the increases to the automatic enrolment minimum contribution levels due in October 2017 and October 2018 with the start of the following tax years. We are told this will make it easier for businesses to deal with the changes.
Having reviewed the detail, however, another benefit emerges – for the Government, not employers. By delaying the increase in pension contributions, the Government nets an additional £820m in tax over the remainder of this parliament. This points to the conflict that dogs effective policy on pension incentives. If more people save in pensions, it costs the Government more in the near term, even if in the long term we all end up better off and pay more tax.
Much is made of how defined benefit schemes are far superior to defined contribution, and how the benefits they offer are far greater than anything that will come from inferior DC schemes. But what is often not said is that the biggest reason for this is DC plans are woefully underfunded compared to DB.
If we are to give the coming generations of retirees any chance of having a decent retirement, we need to see a sharp increase in contribution rates, perhaps even a doubling from the auto-enrolment minimums.
But delivering such an increase has significant costs, both economically and politically. Enforcing a higher level of contributions under auto-enrolment rules could be seen as a stealth tax and, even if successful, would significantly reduce tax receipts through reduced income taxes and lower purchase taxes as a result of deferred consumption.
Trying to raise contribution levels without some sort of compulsion or strong “nudge” is unlikely to deliver satisfactory outcomes. Simply telling people they should save more will not work.
A successful answer to the question of how to incentivise pension saving has to go at least some way to resolving this conflict. How can we encourage increased levels of saving without increasing costs for today’s Government?
Moving to a taxed-exempt-exempt system solves this in a stroke but it has been convincingly rejected by most commentators and the pensions industry as unworkable and unreliable. It assumes future governments will keep the promises made by today’s politicians and, with no disrespect to politicians, it feels that this is a tall order. That does not mean TEE cannot be part of the solution, it just cannot be all of it.
To understand where the answer might come from we have to consider what the purpose of pension incentives is. To my mind there are three answers here: one is valid and the other two are a distraction.
The valid role of tax incentives for pension saving is to make it “safe” or at least marginally attractive to save in pensions compared to other vehicles. Even with pension freedom, saving in a pension means giving up liquidity and there has to be compensation for this. We also need to make sure incentives limit the likelihood of double taxation. This latter objective is hard to achieve within a progressive tax system as it can mean overcompensating those at lower tax rates to ensure those at higher rates do not lose out.
The first red herring is trying to use pension tax incentives to increase overall retirement savings levels. Of course, offering to match individual contributions with a Government bonus will be attractive and gets more so as the rate of matching increases. But it is costly and will naturally lead to a low limit on the level of saving that can be incentivised, which will not solve the problem of not saving enough.
The second red herring is redistribution. Many argue that by having a flat-rate relief set at a level well above the basic rate of tax we can redistribute wealth to the lower paid through the pensions system. This is a laudable aim and we certainly need to address the imbalance of incentives between income level. However, the danger is that we spend a lot of money simply subsidising saving, rather than encouraging greater levels of it.
So to reduce the economic conflict in pension policy we need to focus incentives on just making pension saving a safe thing to do. This will allow us to get the greatest level of saving from a fixed amount of incentives. How we deal with the political conflict of telling people they will not have enough to live on under auto-enrolment is one I will leave to the politicians.
Richard Parkin is head of retirement at Fidelity International