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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions: In search of the Holy Grail

During 2009 a suite of proposals was developed to catalyse a culture of retirement saving, particularly among low earners, to make Britain’s income-in-retirement (note: not ‘pension’) landscape sustainable1. The approach was to consider the state pension, occupational pension schemes, public sector pensions and income derived from personal retirement savings as a single system, with the premise that the structure of the National Employment Savings Trust (NEST)2 scheme — formally the Personal Account — is significantly flawed.

All regulated pensions, including NEST, lack sufficient flexibility to accommodate a U-shaped spending pattern in retirement; high in the early years of active retirement, followed by lower outgoings in the more sedentary years, but then picking up with expensive long-term care. In addition, people increasingly want to work after reaching the state pension age (SPA) and delay the realisation of their retirement-focused savings, with no desire to purchase a lifetime annuity. Access to funds before the age of 55 (from April 2010) is also not permitted; a huge disincentive to saving.

Given low earners’ small contributions, the NEST is also likely to produce derisory income in retirement for them. Why should they forego what little disposable income they may have for an uncertain return, the disincentive reinforced by the scope to lose benefits through the iniquity of means-testing?
Notwithstanding these flaws, the NEST is now under the political microscope; last November’s Pre-Budget Report delayed the introduction of employer contributions to save money; these contributions would have been a tax-deductible expense and attracted national insurance contribution (NIC) tax relief. Shortly thereafter, one of the last two remaining Personal Account Delivery Authority (PADA) systems bidders, Great-West Life, pulled out, leaving only Tata CS; perhaps an untenable situation?

The original proposals (excluding the public sector proposals)
The state pension should be substantially increased 10 years after the SPA to a level that lifts eligible pensioners above the guarantee credit limit and out of poverty.
>> State Second Pension (S2P) accruals should cease. S2P and S2P national insurance contribution (NIC) cash flows would be re-engineered to help finance the additional cost of the larger state pension for senior citizens. Financing is also assisted by more people contributing full-rate NICs.
>> The NEST contributions should be increased to 7% of gross earnings (3% employee with a 1% tax credit, and 3% employer). The NEST is currently based upon 8% of NI band earnings, which is an unnecessary complication and also meaningless to most people. The employee tax rebate rate would therefore be 25% for everyone, providing a significant incentive for 20% taxpayers to contribute more than the 3% minimum.
>> The NEST contributions of the low-paid should be enhanced by the state, perhaps up to 3% of median earnings (about £750 per year). Their asset pools would then be likely to produce a post-SPA income that would help them to be self-reliant in later life.
>> Savers should be free to bequeath their unused NEST assets to third parties free of any inheritance tax liability, provided that the assets go into a retirement savings scheme. This would encourage a cascading of wealth down the generations and reinforce the sense of personal ownership of NEST assets.

Confident that the state would sustain them in their later years, savers would then be free to concentrate their NEST-derived income on 10 years of active retirement immediately following the SPA, rather than having to stretch it out until they die, via a compulsory annuity (which penalises those with shorter life expectancy, often the less well-off).

This approach would substantially boost incomes during the period of more active retirement. Consequently, an amended NEST is more likely to be a suitable retirement savings product, not just for low earners but also for those in their forties and fifties, because it delivers income in retirement relatively rapidly. This would particularly benefit those with shorter life expectancy, as they can realise all of their NEST assets by the time they become senior citizens.

But we should go much further
Annual contributions to the NEST are capped at £3,600, simply because the government buckled under the onslaught of the pensions industry’s vested interests. The consequence is that those who wish to save more will have to engage with at least one other retirement savings vehicle (more complexity) or opt out of the NEST. Indeed, the division between NEST and other savings vehicles is entirely artificial, care of the cap.

Unfortunately, most of us are not equipped to rationalise the array of perplexing products, each offering different attributes that make them hard to compare. At the root of this complexity is tax. We have multiple tax regimes in each of the three phases of long-term saving (accumulation, decumulation and post-death), not least because two very differently taxed industries (savings and pensions) are pretending to be one. If saving for retirement was simplified, we as a nation would save more.

Proposals on exactly how to achieve this will be revealed in the coming months but as an appetiser, consider this: why not bring pensions and ISAs together under a combined annual contributions limit of £40,000, say, with tax relief at the marginal rate? There would then be no need for a lifetime limit. The savings industry could offer a lifetime savings platform (LSP), which would host a flexible, instant-access account (today’s ISA, taxed TEE3, but without the division between cash and stocks and shares) and a retirement ISA (RISA), taxed EET.

The saver should be able to transfer surplus funds from the ISA into the RISA and receive tax relief regardless of other contributions that year. Auto-enrolment into an LSP could come with the option for employers to contribute to either account, although ISA contributions would be a taxable benefit akin to paying wages. Some pre-SPA access to the RISA ought to be permitted (up to 25% of asset value).

Ultimately, we should aim to establish a single, unified tax framework for all tax-incentivised savings products, including tax harmonisation between the savings and pensions industries. This taxation Holy Grail could be the ISA’s TEE, with upfront tax relief (£29.9bn in 2008-09, heavily skewed towards the wealthy) redeployed to boost the basic state pension (£50.5bn in 2008-09) by some 60%; a dramatic simplification that would transform Britain’s savings landscape.

Furthermore, we would then catalyse a virtuous circle because we could recoup a large proportion of the £7.9bn spent on pension credit and achieve a huge saving in administration costs, thereby freeing up more funds to further increase the basic state pension. Only then could the government claim to meet what should be its only pensions objective: to address pensioner poverty by providing a minimum state pension above the means-testing threshold.

A wholly TEE framework does, however, present at least one significant challenge; the lack of an upfront incentive to save for the long term. A compromise could be to cap upfront tax relief to the standard rate of tax (20%), irrespective of the saver’s marginal rate of tax, partly financed by ending the 25% tax-free lump sum at SPA.

There is one further step that could be taken; we could enhance the ISA capabilities and give upfront tax relief (at a flat rate of 25%, say) to attract savings. Any pre-SPA withdrawals would require repayment of the relief, so the net effect would then be TEE, as ISAs today. Post-SPA withdrawals, however, would not require repayment of the incentive, but would be taxed as income; the ISA would then operate as EET. Thus, with hindsight, funds that ended up being locked away for the long term would be taxed as if they were a pensions savings product.

Some degree of asset ‘lock-up’ may be required to ensure that people do have some assets at retirement, but as they approach SPA, the loss of tax relief would be an increasing disincentive to withdraw funds. Post- SPA contributions would not receive tax relief, but withdrawals of these contributions would be tax-free.

This approach would synthesise, in a single product, ISAs’ instant access (as TEE) with the upfront incentive world of pension saving (EET). It could perhaps be branded as a ‘Super ISA’ or Lifetime ISA (‘LISA’), ISA being the most trusted savings brand. It could replace all tax-incentivised pension savings products and, at a stroke, provide the unified tax regime that simplification demands. Britain would then save more.


1 Don’t let this crisis go to waste; a simple and affordable way of increasing retirement income, Centre for Policy Studies, Michael Johnson, September 2009
2 Based upon auto-enrolment (i.e. ‘soft’ compulsion), employees can make contributions of up to 4% on their National Insurance band earnings, plus roughly 1% through normal tax relief, with employers required to contribute a minimum of 3%
3 T, Taxed and E, Exempt. The first letter refers to contributions (of capital), the second to investment income and capital gains and the last letter to income Michael Johnson trained with JP Morgan in New York and, after 21 years in investment banking, joined Tillinghast, the actuarial consultants. More recently, he was secretary to the Conservative Party’s Economic Competitiveness Policy Group

Michael Johnson trained with JP Morgan in New York and, after 21 years in investment banking, joined Tillinghast, the actuarial consultants. More recently, he was secretary to the Conservative Party’s Economic Competitiveness Policy Group