The golden key to pension taxation unlocks pensions for the silent majority of people in this country who have no interest in “pensions”.

The golden key unlocks money currently spent incentivising the wealthy to preserve wealth and allows those who need money in retirement to “save to spend”.

Engaging and empowering our population to work, pay national insurance and income tax and to save , is critical to the great welfare state system we have built.

Currently a large part of that system, private pension saving, is playing too small a part in that process for the money we are throwing at it.

The golden key is to get value for money for all tax-payers -from the public purse.

That golden key

I think the Treasury has found the golden key and it’s in a little known section of pension taxation legislation called “Scheme Pays“.

I wrote about this yesterday and I’ll write about it again as it is important.

Scheme Pays is a taxation technique which allows the nation of savers to transfer from “tax-relief (EET)” to “Government incentives (TEE)” without the pain of a drop in take home pay.

The mechanics are blindingly simple. Instead of pension tax relief, we get a hand-out from the Government which we can call- for now- a Government Incentive (the ABI call it a saver’s bonus).

We pay tax  (and perhaps National Insurance) on all contributions made by us or on our behalf into our pension pot or to get us a defined benefit at retirement. We do not pay this through PAYE, we pay our tax via a deduction from our pot or the docking of our defined benefit (ear-marking). THE SCHEME PAYS.

Pain and Gain

Of course this isn’t necessarily painless. Unless the Government hand-out is at least as great as the tax-relief given up, we will be worse off in the end. I am quite sure that for most traditional pension savers, we will be worse off in the end.

But for those who have not historically enjoyed the benefits of tax relief – those who pay little or no tax , there is an opportunity for the system to be tilted in their favour. Rather than pension taxation being regressive (favouring the rich), it can switch to being progressive (favouring the poor).

Encouraging bad behaviour?

Much has been said against a system of upfront taxation, as imagined here. The arguments take the following forms

1. It reduces the amount actually invested as the Government becomes another fund manager (raking off tax upfront)
2. It relies on incentives that might not arrive till retirement (the final E in TEE means extending the tax free lump sum at the end of saving from 25% to up to 100%.
3. The Government cannot be trusted over a long period not to renege on  distant promises.

All these arguments have merit. The funds industry and those whose platforms rely on a charge on funds under management will have less revenue from a TEE system and there will be less money in the system for long-term investment in equities.

The danger of a tax free lump is that people spend it all at once. In Australia, where this has and is happening, there is a wish to put up barriers to “spunking the cash”.

The jam tomorrow concept of TEE is a worry, there have been many stealth taxes imposed both on benefits and on investments.

The opponents of a TEE system, or at least one that replaces tax-relief by targeted incentives, is that it encourages bad behaviour by Government or bad behaviour by individuals.

Or incentivising good behaviour?

Ros Altmann, who is the Pensions Minister, is against a system of Pension ISAs where we get a big splodge of untaxed money at retirement. She knows human frailty too well, she knows many of us will spend it too quickly and become a burden on others as they grow older.

Michael Johnson, in recent writings, has addressed the problems of Australia (and the concerns of Altmann) and has suggested ways that our savings can be enhanced at retirement if we pursue prudent strategies that ensure our money lasts. He’s converted TEE to TEEN with the final N being a “saver’s bonus” for those who exercise restraint in their spending plans.

Of course this is what happens today when we use pension freedoms, First Actuarial’s  muppotometre allows people to see how by spreading the taking of their retirement funds from 1 year to 20 years, people can move from being 100% muppet to close to 0% muppet (actuarial rounding applies).

Without the barrier of taxation on your money, their has to be incentivisation in retirement. In future you may be a muppet for spending all at once as you miss out on the saver’s bonus that pays out deep into retirement

Can the Government be trusted?

Unlike Steve Bee, I think the Government generally is trusted on savings taxes. There is much more personal saving going into ISAs than into Pensions and money in ISAs is sticking around, despite the value of the ISA wrapper bing on it providing E at the point of future claim.

The difference between pensions and ISAs has narrowed with the introduction of freedoms which give us choice as to how we spend our pension savings. We seem to trust pensions more for having that choice.

What people seem to distrust most is the unknown. Annuities were “unknowns”, nobody knew how they worked, what impacted the income they gave and what they’d be taxed at.

I suspect that it wasn’t the tax treatment of pensions that put ordinary people off pensions, it was the way you bought the “pension”.

Whether Government can be trusted or not, we have to have a system that people understand and have confidence in. Pension Freedoms have made that more possible.

Things have to change

We have a triple whammy in our welfare system which has to change

1. We are spending tax-payers money rewarding those who have wealth and not rewarding those who will poor in retirement
2. We have a welfare system already in trouble and showing all the signs of becoming more expensive (especially around health)
3. We have a big fat hole in the country’s finances that has to be plugged.

I am not so optimistic about our country’s future as to suppose that we will sort this out by working harder, longer and better. I think we have to re-arrange our finances according to what we have. Which is why I am not against a massive tax-raid on pensions as we know them.

And in the long-term?

In the long term we need a better system of pension saving that incentivises good behaviour as the default spending mechanism. I have said many times that a collective drawdown system depending on mortality pooling with minimum reliance on guarantees from insurers and banks, is needed.

My hope is that we can re-ignite the fire for a collective decumulation system as envisaged by Steve Webb in his Defined Ambition project. In the long-term it makes sense.

I accept that no work is going on to develop the rules for such a product and I have told anyone who listens that this is a mistake. The ravages that the current financial blip is causing drawdown strategies should remind ordinary people that we are better together.

In the long-term I suspect that we will become more reliant on collective means of providing for ourselves.

• Through tax-payer funded services such as the NHS and the allowances from the DWP
• Though earned entitlements to a single state pension
• Through collective decumulators for our private savings.

Looked at in the round, if the tax-raid on private pensions which is about to happen, means we have a sustainable state pension paying out at a reasonable rate- I will back it.

If it means we have proper health-care for our elderly, I will give up my tax-reliefs – with relief!

And if we have a system that rewards prudent savers when they come to the end of work, I will work to create the product that allows that to happen.

Restoring confidence starts with the Golden Key

Radically reforming pension taxation is a big endeavour and it will not succeed unless it unlocks the pent up will of the nation to save. We save too little and we don’t like ourselves for it. Auto-enrolment has come as a relief to millions of non-savers who sleep easier at night knowing (however little they save) that they are on their way.

People are trusting pensions more because of Pension Freedoms and if the Golden Key works, they will feel more incentivised to save, because of the budget.

Those who have, will have less – at least less than they expected from future contributions. I cannot grieve for those who are still accruing defined benefits or maxing out tax opportunities into SIPPS and quality workplace pensions.

The Golden Key is not for the rich, it is for the pension poor and it will lead us to further doors which we can unlock in years to come.