By Ben Gaukrodger is a Manager, Savings Policy at the ABI
We recognise that fundamental reform of the existing system is required. Retaining the status quo is just not an option as there is no status quo. There have been frequent changes in the last decade as a way to reduce the total cost of tax relief, which have undermined trust and stability in the system and made it increasingly challenging for employers for administer a pension scheme.
Significantly, the Chancellor explicitly raised the prospect of taxing pensions like ISAs when announcing the consultation. Such a change would flip the existing system on its head – contributions would be made from post-tax income, while withdrawals would be tax free.
Whilst this would bring in immediate tax savings to the Government that would have short-term benefits, the more you look into the so-called Pensions ISA, the more you realise that its attractiveness is superficial and such a move would be reckless.
Undisputed economic modelling by the National Institute of Economic and Social Research has found that a move to a Pension ISA system could reduce GDP by up to 9%. We would also expect significant falls in savings, productivity, real wages and consumption, while real interest rates would increase. These macroeconomic consequences occur even with significant matching payments from Government to take the edge off the change.
Such results are dramatic, but also intuitive. Moving to a Pension ISA system would mean that people would pay tax on contributions to their savings when they are working rather than when they are retired, moving retired people completely out of the tax net.
This would shift the tax burden almost entirely onto the working age population, and the outcome is a reduction in the amount they have to consume and save, which has significant effects for economy as a whole by intensifying an existing and growing intergenerational equity problem.
Considering the Pension ISA in the context of an ageing society, it would exacerbate the problems we are already facing as people live longer and the costs of providing social care increase. This would shift responsibility onto an ever shrinking younger generation who are dealing with high unemployment, increasing house prices and slow real wage growth.
‘Complex system’
The problems with a Pension ISA system aren’t just macroeconomic either; it would also be horrendously complicated for employers and pension providers to implement. So difficult in fact that it is virtually impossible to apply to defined benefit pensions, which account for around three quarters of the total cost of pension tax relief. It isn’t much better for savers – they will be left navigating an even more complex system, with different rules at retirement for savings made before and after the Pension ISA is introduced.
There is also a significant risk that taxing pensions upfront would damage the incentive to save. While the opt-out rates from Automatic Enrolment have been very low to date (about 90% of people remain in their workplace pension), that success is at risk under a Pension ISA system.
As the IFS has rightly highlighted this week, we can expect people to save less if they think a future Chancellor might tax their pension again at retirement. Unfortunately our research shows that only 19% of people trust the Government to leave money they have saved alone. Recent experience in Australia shows that people are right to be wary; in 2007 the John Howard Government made a similar change, so that pension contributions were taxed and withdrawals were tax free. In 2013 Julia Gillard’s Labour Government decided to introduce a tax on withdrawals as well.
‘Savers’ Bonus’
Adopting a Pension ISA system would be a mistake, especially when an appealing, radical alternative exists in the form of the Savers’ Bonus. Our proposed reform, based on a single rate of tax relief, would address the weaknesses of the current system with far less risk. Right now, the average salary earner on £26k who is saving £1,000 a year into their pension, will only get a £250 top up from the Government, compared to someone earning £50k who is saving the same amount, and would receive £667. A Savers’ Bonus would be a fairer deal for all, and those who save for retirement would get the same Government support, regardless of how much they earn. Even better, the Savers’ Bonus can be implemented while still making significant savings for the Exchequer that are sustainable in the long-run. That’s why it’s supported across the pensions industry and by bodies like Age UK and TUC.
The system desperately needs fundamental reform to create a fair and sustainable system that will encourage all earners to save.
But we must not damage our economy in the long term and cause financial problems for future generations.
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