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John Lawson: Why pensions as Isas won’t work in practice

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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

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Absolutely. That is why, in my view, Osborne has instituted these pension ‘Freedoms’. Currently they do not apply to DB schemes the vast majority of which are Public Sector. ‘Freedom’ is the carrot to get the DB members to agree to a DC scheme. This will save the Exchequer a huge amount. If tax relief is then removed he may well have solved the deficit at a stroke – but I really can’t see the DB members opting to commit Hari Kiri and even if they do it will take longer than this Parliament or the next – and we all know how short term all these pension proposals are. So Mr Lawson’s prognosis still looks very robust.

    What is so galling is we have yet another example of policy being made by those who have scant knowledge or realisation of how the system works and as ever joined up thinking is a distant dream.

  2. Ruth Preston-Hoar 11th August 2015 at 9:41 pm

    Good points, John, well made!

  3. What would be interesting to learn is how much of this ‘tax relief’ relates to the public sector schemes.

    It is rather galling that all of these ‘reforms’ are restricting the ability of those who do not have access to a gold plated public sector scheme to build up a decent pension pot.

  4. If the government wants to limit the cost of tax relief on employer contributions, a simple approach (other than the use of a sledgehammer) might be merely to stipulate a specific percentage rate as opposed to the full corporation tax rate.

    As for tax relief on personal contributions, part (albeit it not all) of it will be recouped at a later date, whilst the benefits of pension income being spent back into the economy (not to mention the social benefits of mitigating pensioner poverty) should not be ignored.

    And just what are the alleged imbalances in the allocation of tax relief between the better off and the average worker? Higher earners pay more tax, so why should they not be allowed an equal rate of relief should they (wisely) choose to divert some of their income toward retirement saving?

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