For decades pensions savers have been incentivised through tax relief. Tie your money up for 30 years or more and you’ll receive tax relief at your marginal rate. Not only will you possibly be paying tax at a lower rate in retirement, but you’ll also receive a quarter of your fund tax-free.
But, the government is contemplating ripping up the rule book and completely reinventing the approach to tax relief. In July the Treasury launched a consultation called ‘Strengthening the incentive to save’, although a better title would probably be ‘Making the incentive to save more cost efficient’.
The current tax relief system is incredibly costly to the government. The Treasury forewent nearly £50bn in 2013/14 in income tax and National Insurance contributions, much of which went to higher earners and those with defined benefit pensions.
There is no doubt that this money could be more efficiently applied than it is at the moment, and the Chancellor is right to want to make cost savings in the process, but will making changes to tax relief incentivise savers?
Research recently conducted by PwC revealed 61 per cent are put off pension saving because “the government keeps changing how pensions are taxed”. But, when presented with options for reforming the system, plans to tax pensions like Isas (where there is no tax relief on contributions going into the plan, but you pay no tax on the way out) was the most popular option for savers with 41 per cent stating this would be their favoured approach as it would help them to plan better as they would not need to factor in tax deductions in retirement.
The research suggests that while an Isa style taxation system may prove popular, many savers are concerned that future governments will move the goalposts. Reforming the system could therefore act as a disincentive to pension saving.
If the government is serious about incentivising saving then a rethink of auto enrolment contributions should be top of the list. Research we conducted in 2013 revealed that aside from holiday, pensions are the top priority for job seekers with generous employer contributions being the most important consideration.
Auto enrolment has been working, with opt outs of around 12 per cent according to the Department for Work and Pensions. So securing the success of auto enrolment should be the top priority. That means abolishing the band earnings approach so that 8 per cent of earnings means 8 per cent of all earnings, increasing minimum contributions and, over time, adjusting the balance of employer and employee contributions so that there’s a more equitable split. At the moment, the ‘buy one, get one free’ message is compelling but when employees are contributing 5 per cent and employers are contributing 3 per cent it begins to lose its shine.
If the government wants to save money, there are less drastic measures that could help to shore up the public finances without undermining the entire system. One option open to government would be to remove the 25% tax free lump sum, although this is likely to prove unpopular. Alternatively, it could consider getting rid of salary sacrifice, removing higher rate tax relief or altering the lifetime and annual pension saving allowances. In Denmark, Australia and Sweden contributions are exempt of tax on the way in but a special tax rate is applied to pension fund investment returns and the money is taxed again on the way out. This approach offers another way to raise money for government, but there’s less certainty over the revenue generated.
Tax relief has been a generous incentive for pension saving for decades, yet it took the nudge approach of auto enrolment to bring a step change to the nation’s retirement savings habits – 5.2 million new savers between October 2012 and March 2015. It’s important to remember that we had to resort to auto enrolment precisely because incentives, of whatever colour, were not working.