With the Autumn Statement coming tomorrow we face the usual round of speculation as to whether there will be more changes to pension tax relief. In the run-up to the March 2016 Budget the speculation was about a major shakeup, perhaps replacing tax relief with an ISA-style tax treatment, or moving to a flat-rate of relief for all savers. This time round the speculation is about whether there might be more done to support younger savers, perhaps with a big increase in the rate of tax relief for those at the start of their careers. But can it really be sensible for such a long-term business as pensions saving to be subject to almost constant uncertainty?
To get a sense of the scale of the changes in pension tax relief in recent years, Royal London recently analysed the combined impact of changes to the Lifetime Allowance (LTA) for tax-relieved pension pots and the fall in annuity rates over the last few years. Taking first the LTA, it peaked at £1.8m at the start of the last Parliament before falling every other year to £1.5m in 2012, £1.25m in 2014 and £1m in 2016. Each change has had to be accompanied by complex transitional measures which now cover approaching 100,000 people who are now focused mainly on avoiding pension saving rather than engaging with it.
What has made matters worse is that the pension that you can buy with a given pension pot has also been tumbling because of falling annuity rates. Someone aged 65 who wants to convert their maximum £1m pension pot into a guaranteed income for life with no inflation protection can now only get a pension of around £45,000 per year. This is a fall of around two thirds compared with a decade earlier when both annuity rates and tax limits were higher. More shockingly still, those who want to buy a ‘gold standard’ annuity with protection against RPI inflation and a good pension for a surviving spouse would struggle to get more than £21,000 per year on retirement.
Now it might be pointed out that few people with million pound pension pots choose to spend the whole pot on an annuity. But the same factors which have led to falling annuity rates mean that the return you can get from £1m invested in a drawdown product have also fallen considerably. Greater longevity and falling returns mean that a £1m pot no longer means a lavish lifestyle in retirement, regardless of how it is invested. In addition, the current policy of linking the £1m limit in future to increases only in the CPI means that as wages and investments grow, more and more people will gradually be affected by these steadily reducing limits.
As well as the repeated cuts to the Lifetime Allowance, there has been a cut to £40,000 in the maximum annual amount that can be contributed within tax relief limits. This has been compounded by the introduction in 2016 of absurdly complex ‘tapering’ rules on the annual allowance for those with taxable income plus employer pension contributions in excess of £150,000 per year. These rules have made life particularly complex for those with unpredictable incomes such as the self-employed and those for whom bonuses are a significant part of remuneration.
In sum, therefore, we have seen an extraordinary period of change in the tax regime around something which is meant to be a long-term investment. In addition, the tax breaks for rival investments, notably ISAs and the new Lifetime ISA (LISA) have been substantially increased. From next year it will be possible to save £20,000 per year across a range of ISA products, and the new LISA will give younger savers a top-up equivalent to basic rate tax relief, tax free investment growth and tax free withdrawals for a house deposit or at age sixty. It is hard not to suspect that the Treasury’s long-term destination is a system where pension tax relief is gradually phased out and ISA-style treatment becomes the norm.
So what should be done instead?
In the short-term, we would all breathe a huge sigh of relief if the Chancellor Philip Hammond did not even mention pension tax relief in his Autumn Statement. Whilst there are plenty of things wrong with the current system, a period of stability would be enormously welcome. During the election campaign the Conservatives said that apart from pre-announced changes to tax relief there would be no further changes in this Parliament. If the Chancellor were to reaffirm this commitment it would be exceptionally welcome.
If we are concerned to do more to tackle under-saving, there are other ways that would be more effective than tweaks to the rates and structure of tax relief. The most obvious way forward is to build on the undoubted success of automatic enrolment. Latest estimates by the Department for Work and Pensions suggest that around ten million people will be newly saving (or saving more) as a result of the legal duty on employers to enrol their workforce into a workplace pension. This growth in pension scheme membership is a huge transformation since 2012 and comes after decades of decline.
But the big unfinished business of automatic enrolment remains getting contributions up to a more realistic level. As things stand, the mandatory contribution from employer and employee will reach just 8% of a band of qualifying earnings by April 2019. After that, there is no plan to get savings levels up to more realistic levels. When this is compared with the 20% of salary or more which would have been contributed into a final salary pension scheme in the past (even ignoring deficit recovery contributions) it is clear that the next generation of workers is heading for a much worse retirement than their parents’ generation.
For employers, having large numbers of workers coming up to pension age with small DC pension pots could be a real issue. Even with a new flat rate state pension of around £8,000 per year, many older workers who missed out on DB pensions will be unable to afford to retire. This could mean growing numbers of demotivated workers who want to retire, combined with employers being unable to force them out on age grounds following the abolition of the ‘Default Retirement Age’.
This is not a combination that works for workers or firms. The challenge then is to get people saving more than the legal minimum under automatic enrolment. One option would be compulsory saving, as has worked relatively successfully in Australia. But the politics of this are very difficult, not least given the lack of confidence which many members of the public have in the pensions industry.
A better option would be to build on the insights of automatic enrolment, which have taught us that if you get the defaults right you can get most people to the right place without having to force them. In the context of going beyond 8%, the right ‘default’ option in my view should be a stepped increase in the rate of pension contributions to coincide with future pay rises. This would be in line with the successful ‘save more tomorrow’ experiments in the US, where employees pre-commit part of future pay rises to go into pensions.
These schemes have been very successful in generating high and sustained levels of pension saving without compulsion. In the UK it would be possible to pass legislation which said that, unless workers opted out, each time their pay went up their pension contribution rate would go up until it reached a ceiling. Each time someone changed job, their P60 would show the contribution rate they had reached in their last job and the new employer would come straight in at the new rate.
It would clearly add administrative complexity for employers and pension providers to operate a scheme of this sort. But, short of full-blown compulsion, it is difficult to think of another way to tackle the chronic under-saving of millions of workers in the UK today.
It is always interesting to speculate about the future of pension tax relief, and the twice-yearly cycle of Autumn Statement and Spring Budget gives us plenty of opportunity to do this. But such uncertainty does little to improve confidence in pension saving. The priority surely has to be a period of stability on the tax relief side and to focus instead on what works – getting the behavioural incentives right in workplace pension saving, so that those who take no active decisions end up saving a decent amount and can afford to retire when they – and their employers – want.
Steve Webb is Director of Policy at Royal London
The latest Royal London Policy Paper: ‘Pensions Tax Relief: Time to stop the salami-slicing’ can be found at www.royallondon.com/policy-papers