The Government appears to be moving towards merging pensions and Isas. It stands to save a lot of money if it remains committed to the journey says Centre for Policy Studies fellow Michael Johnson
Successive saving-related policy initiatives taken by the current government could be interpreted as stepping stones towards the ultimate merger of pensions and Isas. These include several reductions in pensions’ lifetime and annual allowances, significant increases in the Isa’s annual limit and, with the addition of a Help to Buy Isa, an expansion of the Isa range, the end of pensions’ so-called “death tax” and the annuitisation liberalisation announced in the 2014 Budget.
There was also a hint in the 2014 Autumn Statement that NICs rebates on employer contributions to pensions could be under review, when the Chancellor said that the Treasury would be taking measures to prevent “payments of benefits in lieu of salary”. Ending them would equalise the tax treatment of employer and employee contributions, and finally put an end to salary sacrifice schemes, long overdue.
From a Treasury cashflow perspective, moving the whole savings arena onto a TEE basis, where subscriptions are made with post-tax income but withdrawals are tax-free, would be hugely attractive. The cash outflow would move back in time, by up to a generation, as upfront tax relief, paid out to today’s workers, would be replaced by income tax foregone from today’s workers, once they had retired a generation later. In addition, transition would provide the Chancellor with an opportunity to make a significant reduction in the deficit. This could be The Great Trade to do.
So what of the Australian experience of implementing changes to pension taxation structure? Until 1983, the tax treatment of Australian retirement savings was EET, i.e. as per the UK today, with lump sums taxed at 5 per cent. The first transition step was to increase tax on lump sums to between 15 and 30 per cent, depending upon the recipient’s income. Then, five years later, in 1988, Australia introduced a 15 per cent tax on contributions and income, and a 15 per cent tax rebate on retirement income: essentially a “ttt” arrangement, where the small “t” denotes an effective tax rate below the individual’s marginal rate of Income Tax. This framework endured for nearly 20 years until, in 2007, Australia removed any tax liability on retirement income in respect of contributions that had already been taxed: “ttE”. Lump sums at retirement attract the lower of the retiree’s marginal rate and 16.5 per cent, up to a size cap, with the marginal rate on sums above the cap.
Australia’s ttE is not so different to TEE: the burden of taxation in both cases falls at the time of saving, with retirement income being tax-free. Australia has pondered whether to go to tEE, i.e. to remove any tax burden during accumulation, but with almost A$2 trillion of assets sitting in the pension system, the government could not afford to leave it completely untaxed.
Australia’s transition experience to ttE was not ideal; it has left savers and providers having to keep track of pots with three different post-retirement tax treatments, depending upon the timing of the contributions. In the interests of simplicity, the UK should grasp the nettle and adopt a clean “Big Bang” approach, to avoid some form of protracted, progressive, transition. The Treasury should identify a date when EET simply ceases in respect of all future contributions. Existing pension pots would close to further contributions, to be left to whither naturally, with the saver paying his marginal rate of income tax on withdrawals.
So, what should replace private and occupational pensions in a purely TEE savings arena?
The Workplace Isa beckons and, for those without an employer sponsor, alternative competing providers should be available, including Nest – the Nest Isa. These Isas could incorporate a form of risk pooling in decumulation to spread the post-retirement inflation, investment and longevity risks that few of us are equipped to manage by ourselves. Participation, however, should be optional, enabling savers to embrace the 2014 Budget’s post-retirement liberalisations, notably, to take cash from pension pots.
Workplace Isas should include one or more features that maintain employer participation in retirement saving provision: today, employers contribute roughly 75 per cent of all pension contributions. Any financial incentives, such as NICs rebates on employer contributions – note that TEE refers to the saver’s Income Tax, not employer NICs – should, however, probably be accompanied by some form of “lock-up” period. Certainly, employers should be consulted. Workplace Isas should be included in the auto-enrolment legislation, and excluded from means testing purposes, as per today’s pension assets.
Finally, we could explore evolving TEE into “Taxed, Exempt, Enhanced”, redeploying some of the savings from having ended upfront tax relief into post-retirement top-ups: particularly appropriate given today’s interest rate environment. The Swiss, for example, subsidise annuities, which perhaps explains why they have the highest level of voluntary annuitisation in the world – some 80% of pension pot assets. We could extend the concept to include drawdown.