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Learning tower of Pisa

Prudential has developed the concept of the pension Isa – which draws on extensive research into financial decision-making – as an idea to encourage the savings habit among middle earners. Here, UK director of pensions development John Glendinning describes how it works.

Five months ago, the Pensions Commission threw down a gauntlet to all those who continue to resist compulsion and believe that the voluntarist system – although not perfect – is fundamentally better for consumers than the blunt instrument of compulsory pension savings.

The challenge is to make the voluntarist system work, especially for people earning between 15,000 and 30,000. Why these people in particular?

The commission’s analysis more or less divides the population into three groups. Everyone earning below 15,000 will mostly be catered for by the state system. At the other end of the scale, those on earnings above 30,000 will either have access to a good occupational scheme or else will have the dangling carrot of higher-rate tax relief to encourage them to save. In other words, they are catered for by the private system.

It is in the middle group earning between 15,000 and 30,000 where the commission suggests the biggest challenge lies. The level of income that these people would like in retirement is not provided by the state, yet many in this group do not have an employer who makes contributions to a company scheme.

As a way to encourage the savings habit among low to moderate earners, Prudential has put forward the idea of a pensions Isa as part of our response to the Pensions Commission’s report. The acronym we are using is Pisa. (Predictably, a number of my colleagues assure me that people are leaning towards it.)

Pisa is essentially a cash Isa with accessible funds written within a pension scheme. There would be targeted incentives to move those funds into the locked main part of the pension scheme.

A saver would be able to contribute, say, 1,200 or so to the cash account, where interest would accrue tax-free. Transfers from the cash account into the locked box would receive an additional tax incentive in the form of a Government matched contribution at some rate between 50p and 1 for every 1 transferred. This would be available for, say, the first 1,200 of transfers each year. Contributions above this level or from other sources would receive tax relief as normal. There would be no need to make any changes to the post-2006 regime which is currently being implemented since the accessible cash account would sit on top.

Where does this fit in with the target savings market? Well, the matched contribution could be targeted to encourage saving among key groups that are currently undersaving but receive relatively poor incentives to increase their saving – perhaps those with earnings between 15,000 to 30,000. We suggest the matched contribution should not be available to higher-rate taxpayers and could be more generous for younger savers. This last feature could kickstart the pension savings habit by younger people.

We know from extensive research, especially in the US, that consumers do not always make financial decisions logically. The power of passive decision-making through auto-enrolment techniques for pension schemes is a clear testament to that. Understanding how people will behave when presented with an overall savings proposition is a key part of creating the right conditions for success in the voluntarist environment. On those grounds, the Pisa may be able to claim some positive features.

For example, it would be safe to use auto-enrolment to the Pisa cash account because the funds remain accessible and there is no risk of losing capital value. The key issue is what people will do next. Although the funds remain accessible, the potential incentive of matched contributions and the fact that the funds may be perceived as semi-locked may act as a disincentive for people to withdraw funds.

The second aspect of the Pisa concept aimed at playing to behavioural responses is an element of “use it or lose it” on the Government’s matched contributions. Savers might be encouraged to make pension contributions via the Pisa to take advantage of the matched contributions but “use it or lose it” on a year-by-year basis is probably too restrictive and allowing individuals to roll up their allowance for up to five years might be more effective.

Towards the end of each fiscal year, people with Pisa cash funds would be presented with short-term decisions for their accumulated funds. Do they accept the Government’s matched contributions and lock away the funds for their retirement? Do they consider reducing some debt by withdrawing funds? And, of course, a further option is that they withdraw the cash and spend it.

People will behave differently at different times and could be encouraged by Government advertising in the run up to the end of the fiscal year to make the socially-responsible decision of saving for their retirement.

It is clear that today’s lifestyles need new thinking. Lifetime accounts are a key response to that changing consumer need. We believe that the Pisa concept has many advantages, both in playing to how people may behave in their financial decision-making and in leaving undisturbed the pension tax regime just going into place.

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