Please don’t discourage saving (guest blog from Ralph Frank)

pig2

 

The Department for Work and Pensions (“DWP”) recently released its latest “scenario analysis of future pension incomes” (the “Analysis”). A key finding of the Analysis is that the proportion of people under-saving for retirement increases as income rises. Part of the under-saving can be explained by the impact of the State Pension falling as income increases. The diminishing effect of the State Pension exposes the insufficient level of private savings by savers. This lack of private saving might well be an issue of affordability, as noted in the Analysis, with “middle income groups” needing to save over 8% (paragraph 128) and “high earners” having to put away more than 15% (paragraph 127) to avoid under-saving. However, another factor might be at work too – the maximum amount of pension saving that can be built up with the benefit of tax relief, known as the ‘Lifetime Allowance’ (“LA”).

 

 

The current Government has implemented a raft of measures (e.g. Auto Enrolment, simplification of the State Pension, freedom and choice at retirement etc.) to encourage greater pension provision, particularly from private sources. This encouragement has, however, been curbed by a reduction in the LA. The LA is a fairly blunt tool aimed at limiting tax avoidance – in theory, not a bad idea (curbing tax avoidance rather than the blunt tool!). However, it is the execution of this idea that, in my opinion, contributes to the under-saving identified in the Analysis.

 

The LA is a specified capital amount, despite income in retirement being a more relevant metric for pension saving to my mind. An income-related assessment is made for those receiving a pension from a Defined Benefit (“DB”) scheme. The LA is seemingly unrelated to financial market conditions too. The peak level of LA applied over 2010-12 at £1.8m and the LA has subsequently been cut to £1.25m for 2014-15. The reduction has taken place during a period of falling bond yields. The capital required to provide a specified level of post-inflation income to a 65 year old retiree and their spouse has increased by more than 20% over the period of the LA cuts. Consequently, the effective reduction in the level of retirement income benefiting from tax relief has been almost 50%!

 

The £1.25m LA equates to a gross of tax income in retirement of not much more than £30,000 p.a. in current markets for a 65 year old who wants an income that escalates in line with the Retail Prices Index and has a 65% spouse’s benefit (for a spouse who is three years younger). Is it a surprise that under-saving increases dramatically as pre-retirement incomes approach and exceed this £30,000 level? The incentive savers have to provide for themselves, even after allowing for a lower required level of income post-retirement than pre-retirement, is removed and savers respond accordingly.

 

Some savers might find themselves in breach of the LA even if they do curb their level of contributions. This breach might arise from the savers’ investments performing strongly in capital terms (even if not in terms of income in retirement). Is it Government’s intention to penalise successful investors?

 

Those who receive their pension from a DB scheme are not affected by investment outcomes, in the context of the LA. DB recipients also benefit from their LA assessment ignoring whether their pension is payable to a dependent after the primary pensioner’s death. The dependent’s pension might well be extremely valuable, particularly in the case of a much younger dependent. The value of the total pension is, for example, around 35% higher if the dependent is 20 years younger than the primary pensioner rather than three years younger (based on a 65% dependent’s pension).

 

A more effective mechanism than the LA is required to balance the need to stimulate private pension provision against that of curbing tax avoidance. Different mechanisms are appropriate for different types of schemes, although clear equivalence would be welcome. An accrual limit (say 1/50th of relevant salary, subject to a maximum limit, for each year of service) would work for DB schemes. A contribution limit is relevant for defined contribution schemes, ideally linked to retirement income by taking age and prevailing interest rates at the start of the tax year into account. Implementation practicalities might dictate that a flat rate, along the lines of the current £40,000 p.a. for 2014-15, is more workable though. A contribution limit might well also be relevant for Shared Risk schemes, as and when these come into being. Whatever the approach ultimately taken, why not remove barriers to reasonable saving as far as possible?pig2

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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