Proposing the idea to treat pensions like Isas and actually doing it are two very different things. Defined benefit pensions are one of the key stumbling blocks that will prevent this idea becoming reality.
There is no denying tax relief given to pension savers is a large number: £34bn at the latest count, excluding the cost of national insurance relief on employer contributions. It is, therefore, no surprise that the Treasury is looking at this (again) as a potential revenue saver.
Equally revealing is how this number breaks down between DB and defined contribution schemes. An enormous £25bn, or 72 per cent, of the whole amount spent on tax relief goes to DB schemes. DC pensions, meanwhile, account for just £9.5bn of the total, of which £7.3bn is up-front tax relief and £2.2bn is the cost of gross roll-up in DC savings.
With this in mind, even if you completely “Isa-ised” DC pensions the saving would only be £7.3bn. Meanwhile, DC savers will need some encouragement to lock their savings away until age 55, so at least some of that amount would have to be spent on another form of incentive.
That incentive will not be generous. Post-auto-enrolment, there will be 15 million DC savers. The £7.3bn figure shared out among this group would only amount to £486 a year per head. This amount of tax relief would imply a total pension contribution of about £2,400 for a basic rate taxpayer, or about 9 per cent of pay for the average earner.
Therefore, even under the current rules, DC tax incentives can hardly be described as bloated.
On the other hand, the average tax relief per active member of DB schemes today is £3,500. A large part of this may relate to deficit recovery contributions. However, given the generosity of DB schemes where funding rates are now around 30 per cent for most schemes (versus around 9 to 10 per cent for DC), the tax relief cost of new accruals is also substantial.
It has been suggested by some that two different regimes are created: one for DC, in which no up-front tax relief is available, and one for DB, where the existing rules continue. Such an outcome is likely to fail for two reasons.
Firstly, it creates a “them and us” situation, where the lucky minority in DB schemes continue to enjoy tax incentives funded by the majority who do not themselves have access to DB schemes. This is compounded by the fact most of the members of DB schemes are public sector workers where the employer contribution of between 15 per cent and 20 per cent of pay is also funded by all taxpayers.
The taxpayer would be funding pension costs and tax relief for an average earning public sector worker of £7,500 a year, while the vast majority of (non-public sector) taxpayers receive next to nothing themselves.
Secondly, if the cost of tax relief is to be made “sustainable”, DB has to be a key target, since it already accounts for nearly three-quarters of the total tax relief spend.
It would, of course, be possible to Isa-ise DB pensions by simply removing tax relief.
This might rightly cause employers some angst, particularly in the private sector where most of these contributions relate to deficit recovery rather than new accrual. Those deficits were run up during a time when tax relief was available, so having the goalposts moved retrospectively would feel unfair.
Removing employer relief will, therefore, be met with stiff employer resistance.
Another alternative would be to tax only new accruals, with the tax bill for both employer and employee contributions falling on the employee. Under this scenario, employers would continue to receive both corporation tax and national insurance relief on their contributions.
However, with total funding costs of DB accruals around 30 per cent, the tax bill for a basic rate taxpayer would be 6 per cent of pay and for a higher rate taxpayer 12 per cent. Against a backdrop of public sector wage rises pegged at 1 per cent for the next four years, effectively cutting pay by between 6 per cent and 12 per cent would cause uproar among public sector workers and their unions.
For these reasons, the solution that emerges from this consultation is likely to be less radical than the initial sound bites.
But that does not mean the consultation cannot be productive. It can still allow us to address the imbalances in the allocation of tax relief between the better off and the average worker and, as highlighted here, the imbalance between DB and DC.
Tax relief also needs to act as a clear incentive to save, so it must be easily understood and valued. This is why we believe a simple matched contribution “you pay £2, we give you £1” is the best and fairest way to tackle these imbalances.
John Lawson is head of pensions policy at Aviva