The UK chancellor’s most radical idea in a radical budget was to turn the current system of pension taxation on its head. Instead of money going into a pension tax-free and then being taxed when withdrawn, George Osborne wants to consult on taxing the income that people pay into their pensions and allowing tax-free withdrawals when they retire. The benefits to the exchequer of such a change are clear — taxes brought forward for a potential windfall of £40bn — but the resulting impact on retirement savings would be dire.
According to a Chatham House report, the UK is due to experience “an impoverishment of its middle class in retirement” based on current savings patterns. The top and bottom income quintiles look OK but the low savings rates among middle-income households create a large gap between pre- and post-retirement incomes and lifestyles. Forfeiting the current top-up of 20-45 per cent (depending on one’s taxable income) on money put into an approved retirement plan would remove the key financial incentive to lock away funds for the future. Without that, Britain’s already low level of retirement savings would fall further.
The FT’s economic columnist Chris Giles says in his column that the Osborne proposal is simpler, more neutral, more acceptable and fairer than the present system. His claims of simplicity and neutrality cite the supposed benefit of treating pension savings the same as spending on property, individual savings accounts, jewellery and cars — that is, not interfering with people’s choices about when and on what to spend their income. But the whole purpose of tax incentives to save for retirement is to shift people’s choices in that direction and away from current consumption or property. The alternative is an increasing demand for higher state pensions or welfare top-ups. With an ageing population and the constraints on future public spending, the last thing the government should do is remove an upfront incentive to save for retirement.
The fairness and acceptability arguments rest on the fact that those in a higher tax bracket benefit more from the current deferred taxation approach than those on lower incomes. This can be easily remedied by limiting the tax-free break on contributions to the lower tax band of 20 per cent for everyone. That would still comprise an attractive incentive to save for retirement out of current income. Limits have already been placed on the annual amount that individuals can contribute to their pension pot and its total accumulated value. If, in some people’s view, these limits are unacceptably high, they could be lowered without destroying the relative merits for everyone of locking funds away for retirement.
One reason that the British are so reluctant to save through conventional retirement products is the unpredictability of the tax and regulatory regime around pensions. Chopping and changing is a disincentive in itself. Yet nearly every Budget in recent years has contained a proposal to tinker with one aspect or another of personal pensions. Unless government shows it can be trusted with stable policy on our savings, we will continue to put our money into property — which has its own macro-economic consequences.
This commentary appeared in The Exchange on FT.com on 23rd July 2015