This week’s UK Budget has revealed the usual muddle amongst politicians, journalists and the public over the whole issue of pensions and savings – with opinion strongly favouring several flavours of having your cake and eating it. This masks some profound and sensible reforms carried out by the coalition government.
First version of the cake. We like people to save. But we want them to spend to promote economic growth. We worry that a large part of the population will become dependent on the state and taxes because they save too little. But when they do, as in the early part of the 2008/09 crisis, we bemoan that fact that people aren’t spending and so causing economic slump. So interest rates crash to the floor in an attempt to reduce savings and increase consumption (alongside the vain hope that companies will be encouraged to invest more).
Next version. We want people to save more to not be dependent on the taxpayer, but we also want target state spending on the less well off, and tax the rich to pay for it. So we encourage people to save, and then confiscate the proceeds.
Another version of this is that we love the idea of exempting pension saving from tax but think that people who have accumulated sufficient savings for a reasonable pension (a million pounds for a pension of £35,000, for example) are part of a rich elite whose broad backs should carry the largest burden.
There is a genuine dilemma at the heart of this of course. For that reason a lot of hope resides in get-out-of- jail-free cards. One of these is strong economic growth. But that requires lots of people to work – which means retiring later and allowing immigration. We are clearly entering an era of low growth, thanks to demographics, personal preferences (i.e. people choosing unpaid leisure over work) and the changing nature of technological advance and the global economy. Remarkably few people have tried facing up to the consequences of this. Even some intelligent economists think that “trend growth” is a law of nature. Another get-out-of-jail-free card is that rising property values will compensate for lack of saving. Collectively this cannot make sense, but it has worked for many individuals, who therefore don’t engage with wider worries about the future.
Now let’s consider some difficult facts. I have already mentioned that economic growth is likely to be much lower in future. The next difficult fact is that private pension saving has collapsed in the last 25 years. Generous final salary schemes have been replaced by inadequate money-purchase schemes. It is now use just blaming Gordon Brown’s tax raid on pension schemes in the later 1990s for this (or Mrs Thatcher’s ill advised liberalisation of pension selling before that) and some are prone to do when you mention this. This at worst mildly accelerated a growing trend. The economics of businesses supporting these pension schemes became toxic even without the tax changes. This means that, as a generality, most people will not now have adequate private sector pensions. Instead as they approach retirement they will have accumulated a few tens of thousands of pounds in probably several schemes.
The next difficult fact is that the economics of long-term saving are toxic for all but the very well off (liquid assets of over £0.5m, say). The poor face the prospect of losing entitlements to state benefits if they accumulate wealth. Everybody will see any savings eaten away by costs which, even without a host of rip-offs, will always weigh most heavily on those with smaller savings. It becomes perfectly rational for a lot of people to not to bother with pensions savings – unless you count trying to own your own home.
When you consider all this, the attraction of tax funded state pensions become clear. That is why the current government has been right to make it reasonably generous, notwithstanding criticism form the right that we can’t afford it. It was also right to make this pension independent of private saving.
Now, what about the tax treatment of savings? To simplify, there are three groups of tax privileged savings. The first is domestic property. To buy your own home you pay out of taxed income and stamp duty on the purchase price, but the gain is exempt from tax. The second is Individual Savings Accounts (ISAs), which, like property, are paid for out of taxed funds (subject to an annual limit) but income and capital gains are tax free. And third are pension plans, for which contributions are exempt from income tax, but it is taxable on drawdown.
The first and last of these are problematic. Domestic property because its tax exempt status has made it a highly attractive investment – but instead of this fuelling much in the way of building new, efficient property, it has simply driven prices up, making ownership out of reach for many younger people and driving a wedge between families with property and those without. Pensions are a problem because that particular route for providing tax exemption makes for maximum complexity. In fact they have become so hedged about in rules that most people don’t understand them.
ISAs, on the other hand, have an elegant administrative design which makes them easier to own than even taxed assets. They also have more chance of channelling investment into more productive parts of the economy.
Here’s why this week’s proposed reforms make sense. Currently money purchase pensions are forced to buy annuities, except in some carefully crafted circumstances, which tend only to apply to the better off savers. The original fear behind this annuity rule was the worry than pensioners would blow their savings quickly and then throw themselves into the arms of the state. But the state of private pensions is such that most people will rely on the state anyway, and most pension pots are so small that the amount of income that would be derived from an annuity would be derisory (and, presumably, a lot of value would be lost in administration costs). And those with larger pots are likely to be prudent with their wealth. If done properly, this will simplify the pension system, and make private pensions more attractive.
Extending the ISA allowance is more controversial. Many simply view this as benefiting the wealthy, as nobody else can save up to the £15,000 a year limit. There is some truth to this, but it will help level the playing field between financial investments and owning your own property. Since it is unthinkable to tax capital gains on homes, it may help to make other assets comparable in their tax status.
A lot of nonsense has been uttered as commentary: fears over people blowing money on cruises and fast cars – or rushing into buying property. My main worry is that the reforms will make it easier for better off people to save for their children, to pass on at death. This could reinforce the effect of inherited wealth, which is already growing. There may be mounting pressure to reduce Inheritance Tax.
But overall this looks a sensible step forward – and actually quite brave. It is surely no accident that unlike its predecessors the current government’s Pensions Minister, Steve Webb, really knows his stuff, and has been kept in post for the whole period. Liberal Democrats can take pride that he is one of theirs. There is strong political consensus in his reforms, and no party political benefit. But it is nice to feel that our party has contributed something useful to the process of government.