Today, two disparate worlds
The savings landscape is characterised by a fundamental schism. Saving within a pensions framework provides tax relief on the way in (“EET”), whereas subscriptions to New ISAs (“ISAs”) are made with post-tax income, but withdrawals are tax-free. Consequently, ISAs are “TEE”.
Over the last six years, stocks and shares ISA subscriptions have increased by 90%, to £18.4 billion in 2013-14, taking the total market value to £241 billion. In the same year, an additional £38.8 billion was subscribed to 10.5 million cash ISA accounts, taking the ISA cash mountain to £228 billion. Clearly, engagement with ISAs is high, confirmed by industry surveys, and acknowledged by the Chancellor when he raised the annual subscription limit by 30%, to £15,000, in the 2014 Budget. Importantly, the ISA brand is still reasonably trusted.
Conversely, over the same period, the amount contributed to the EET world of private pensions reduced by 25%, to £7.7 billion in 2013-14, a figure which includes basic rate tax relief. Official data excludes SIPPs and SSASs, which attracted perhaps another £6 billion.
It is clear from the manner in which basic rate taxpayers are saving (i.e. 84% of all taxpayers) that the lure of 20% tax relief on pension contributions is insufficient to overcome pension products’ complexity, cost and inflexibility (until the age of 55), as well as a widespread distrust of the industry. In addition pension products are increasingly at odds with how people are living their lives, particularly Generation Y (broadly, those born between 1980 and 2000). Ready access to savings is the key requirement, valued above tax relief. Indeed, Generation Y is so disengaged from private pensions that the industry’s next cohort of customers could be very thin. Consequently, they are missing out on upfront tax relief: an EET tax framework for retirement saving is failing the next generation.
The 2014 Budget
Following the 2014 Budget, there is now no obligation to annuitise a pension pot. This shatters the historic unwritten contract between the Treasury and retirees, that the latter, having received tax relief on their contributions, would subsequently secure a retirement income through annuitisation.
This expectation was made clear by Lord Turner’s Pensions Commission, which explicitly linked the receipt of tax relief with annuitisation, thereby reducing the risk of becoming a burden on the state in later life. “Since the whole objective of either compelling or encouraging people to save, and of providing tax relief as an incentive, is to ensure people make adequate provision, it is reasonable to require that pensions savings is turned into regular pension income at some time.”
In addition, a subsequent review of annuities by the Treasury stated that the fundamental reason for giving tax relief is to provide a pension income. Therefore when an individual comes to take their pension benefits they can take up to 25 per cent of the pension fund as a tax-free lump sum; the remainder must be converted into a pension – or in other words annuitised.
It is patently clear that tax relief and the 2014 Budget’s liberalisation are incompatible: the door is wide open for wholesale reform, not tinkering, of tax relief. This has been recognised by the Treasury Select Committee which, in its response to the 2014 Budget, commented that in light of pensions’ improved flexibility, ISAs and pensions will become increasingly interchangeable in their effect. It went on to suggest that the government should work towards a single tax regime to reflect this, and also examine the appropriateness of the present arrangements for the pension 25% tax free lump sum.
The committee chairman, Andrew Tyrie MP, was clear: in particular, there may be scope in the long term for bringing the tax treatment of savings and pensions together to create a "single savings" vehicle that can be used – with additions and withdrawals – throughout working life and retirement. This would be a great prize.
Pensions tax relief: expensive
Today’s tax-based incentives for pension saving are hugely expensive, totalling over £52 billion in 2013-14, in the form of:
(i) upfront Income Tax relief on contributions (£27 billion);
(ii) NICs rebates related to employer contributions, facilitated by salary sacrifice schemes. These take advantage of a tax arbitrage at the Treasury’s expense, and cost some £14 billion annually (a figure that will accelerate with auto-enrolment);
(iii) roughly £4 billion on the 25% tax-free lump sum; and
(iv) some £7.3 billion in respect of the investment income of both occupational and personal pensions schemes assuming relief at the basic rate of tax. HMRC does not make an estimate of the relief provided for capital gains realised by pension funds.
To put this into perspective, this is over 93% of 2013-14’s Total Managed Expenditure the Education (£56 billion), and substantially more than Defence (£43 billion), and about the same as the combined budgets for Business, Innovation and Skills (£33 billion), Transport (£14 billion) and Energy and Climate Change (£8 billion).
Pensions tax relief: inequitable
Income Tax is progressive, so tax relief is inevitably regressive. Consequently, the broad acceptance by society that higher earners pay higher rates of Income Tax is nullified because affluent baby boomers are able to minimise their Income Tax by harvesting tax relief on pensions contributions. And for those within touching distance of the private pension age of 55, shortly thereafter, they can access their pots to withdraw the 25% tax-free lump sum and, in many cases, drop down to a lower tax bracket before making further (taxable) drawings. Only one in seven (roughly) of those who receive higher rate tax relief while working go on to ever pay higher rate Income Tax in retirement. In this respect, tax relief is not Income Tax deferred, as claimed by proponents of higher and additional rates of tax relief.
Consider some evidence. In 2012-13, 10.8 million workers received tax relief of £28 billion on their (and employer) contributions, while a similarly sized pensioner population of 11.4 million paid only £11.5 billion in Income Tax. This latter figure will rise as the population ages, but there is no prospect of the Treasury recouping its investment through Income Tax paid by pensioners. Higher and additional rates of tax relief are at a huge net cost to the state: they are a bad investment of taxpayers funds. Recurring budget deficits are one by-product of this financial largesse (which makes a nonsense of the headline 40% and 45% rates of Income Tax), and the accumulating debt mountain will loom over the next generation.
Another consideration concerning fairness is that Treasury-funded tax relief boosts the volume of assets that fund managers have to manage, and therefore their income. Indeed, the Treasury is the fund management industry’s largest client: since 2002, it has injected, through people’s pension pots, over £300 billion of cash, on which charges and fees are levied. This is akin to a state subsidy of one of the highest paid industries in the world.
Pensions tax relief: ineffective
The purpose of a tax relief is to influence behaviour. However, it is evident that for many of the wealthy, tax relief on contributions to pension pots is primarily a personal tax planning tool, rather than an incentive to save: they would save without it. Consequently, it is extraordinary that we accept a framework which provides the top 1% of earners, who are in least need of financial incentives to save, with 30% of all tax relief, more than double the total paid to half of the working population. This inequitable distribution of tax relief partly explains why the huge annual Treasury spend has failed to meet the policy objective, which is to establish the broad-based retirement savings culture that Britain desperately needs.
In addition, tax-based incentives to save have been found to be largely ineffective because most people (perhaps 85% of the population) are passive savers: they do not pro-actively pursue such incentives. Default (“nudging”) policies are deemed to be far more effective for broadening retirement savings across those who are least prepared for retirement, i.e. lower-income workers, in particular. The Danes, for example, concluded that for each DKr1 of government expenditure spent on incentivising retirement saving, only one ore (DKr 0.01) of net new savings was generated across the nation. Given that Denmark is not wildly different to the UK (both culturally and economically), one could conclude that much of the UK Treasury’s spend on upfront tax relief is wasted. So, what to do?
Savings tax unification: inevitable?
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:
(i) several reductions in pensions’ lifetime and annual allowances, from £1,800,000 and £255,000 respectively in 2010-11, to £1,250,000 and £40,000 today (with the lifetime allowance being further cut to £1 million in 2016);
(ii) significant increases in the ISA’s annual limit (up 30% to £15,000 in the 2014 Budget) and, with the addition of a Help to Buy ISA (2015 Budget), an expansion of the ISA range;
(iii) the end of pensions’ so-called “death tax” (announced at the Conservative Party conference), followed by its abolition for ISAs (2014 Autumn Statement); and, of course,
(iv) the annuitisation liberalisation announced in the 2014 Budget, effective April 2015.
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.
The Treasury’s perspective: TEE preferred
From a Treasury cashflow perspective, moving the whole savings arena onto a TEE basis 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.
Implementation: the Australian experience
Until 1983, the tax treatment of Australian retirement savings was EET, i.e. as per the UK today, with lump sums taxed at 5%. The first transition step was to increase tax on lump sums to between 15% and 30%, depending upon the recipient’s income. Then, five years later, in 1988, Australia introduced a 15% tax on contributions and income, and a 15% 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%, 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.
Big Bang preferred
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
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 (i.e. auto-protection), 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% 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. A forthcoming paper will go into more detail.
A version of this article first appeared in CSFI’s Financial World magazine, April 2015.
Michael can be contacted on email@example.com Twitter: @Johnson1Michael
 Retirement savings products are codified chronologically for tax purposes. Pensions are “EET”, as Exempt (contributions attract tax relief), Exempt (income and capital gains are untaxed, bar 10p on dividends), and Taxed (capital withdrawals are taxed at the saver’s marginal rate). Conversely, ISAs are “TEE”.
 HMRC; Individual savings accounts statistics, Tables 9.4 and 9.6, August 2014. In 2013-14, 3m people contributed an average of £6,163 to their stocks and shares ISA.
 For 2012-13, HMRC; Table Pen 2, Personal pensions, February 2014.
 A New Pension Settlement for the Twenty-First Century: The second report of the Pensions Commission (2005).
 HM Treasury (2006), The Annuities Market.
 HMRC; Cost of Registered Pension Scheme Tax Relief , Table Pen 6, February 2015.
 HMRC (2013); Personal Pension Statistics.
 HMRC; Personal Pension Statistics, Table Pen 6, February 2015.
 Chetty R, Friedman J, Leth-Petersen S, Nielsen T, and Olsen T (2012), Active v. passive decisions and crowd-out in retirement savings accounts: evidence from Denmark. NBER Working Paper, No. 18565. Available at: obs.rc.fas.harvard.edu/chetty/crowdout.pdf.