How can tax relief be used to encourage saving?

The ‘Strengthening the incentive to save’ consultation launched in the Summer Budget aims to find a solution to this issue, especially as the burden shifts from the employer to the individual.

It stresses: “The increasing prevalence of defined contribution schemes has increased the importance of ensuring that individuals are contributing enough to their pension.”

Ian Neale, director at pensions technical specialist Aries Insight, says the problems people retiring with DC pensions will face are still emerging, but points out the current average £30,000 DC pot would buy a relatively small annuity of £1,500 a year.

This means a pensioner relying on an average DC savings pot would need to be supported either with a DB scheme, which are becoming rarer, or state benefits.

John Wilson, head of technical at consultancy JLT Employee Benefits, says people are not saving enough for retirement and describes the UK as a “nation of dependents”.

Wilson fears an increasing number of people may rely on means-tested state benefits in retirement which, combined with the UK’s ageing demographic and increasing longevity, will stretch the Treasury’s resources and could lead to rising income tax rates.

One of the consultation’s flagship proposals is “fundamental reform of the system so that pension contributions are taxed upfront”. It is thought this system “may allow individuals to better understand the benefits of contributing to their pension”.

This has prompted a mixed and at times critical response from the industry.

Changing tax relief from the current exempt-exempt-taxed system, to a taxed-exempt-exempt one would require radical reform of how pension funds are administered. And crucially, the benefits to be gained from this system are unknown. 

Will taxing contributions be a barrier to saving? 

As the current system offers tax relief on pension fund contributions to encourage saving, individuals could be put off by having to pay tax upfront for tax-free income they may not be able to access for decades.

In a Hargreaves Lansdown survey of 2,300 investors released last week, 45 per cent said removing upfront benefits would lead to them saving less – more than twice the number who said they would save more.

This proportion rose to more than 60 per cent where only savers below the age of 40 were considered.

When asked if TEE could have a negative effect on saving, Neale says: “It certainly will. Instead of people seeing their contribution boosted it will be depressed.”

However, he adds that a more fundamental issue with the proposed system is that individuals and employers will be entirely reliant on government promises.

It would be impossible to guarantee that funds deposited under TEE would not be taxed again if tax relief later returned to an EET system.

Even if provision was made to keep EET and TEE funds separate, there would be significant administrative costs in maintaining two different structures.

What can be done to encourage saving? 

Both the Pensions Policy Institute and JLT are working on reports studying the effects of changing the way pensions are taxed.

JLT’s preferred solution is a single rate of tax relief under the EET regime, expressed through the government topping up pension contributions with a proportion of the amount invested. This would be in conjunction with a £40,000 cap on lump sum withdrawals.

Hargreaves Lansdown’s survey shows that 51 per cent support matching contributions, compared with 26.9 per cent for the current system and 22.1 per cent for a system with no upfront tax relief.

The most popular matching set-up was a 33 per cent flat rate, where the government would contribute £1 for every £2 invested in a pension scheme.

David Robbins, senior consultant at Towers Watson, says it is hard to predict what effect matching contributions would have on saving, particularly as the system’s “generosity can’t [be] known at the moment”.

Neale says these top-up payments “will be a stimulus [but] you have to question the rationale” behind the government’s decision to make these reforms.

He suggests that the government is prioritising an immediate boost in government income over establishing a sustainable pensions policy.

Robbins also points out the government top-up would be easy to change and “chancellors might be tempted to mess around with it”.

Similar to the argument that there is no guarantee that TEE will not become TET, there can be no assurance that top-up rates would remain at the levels initially set, or relief would remain a single flat rate. 

Will it be enough anyway?

Though these measures could contribute to increasing levels of saving, they may not be sufficient.

JLT’s Wilson expresses concern about adequacy. He says: "There is a core element of those not making adequate provision for retirement [who] will not change their behaviour.”

He says future governments will have to consider compulsory measures to ensure that enough is saved for retirement.

But if compulsion is necessary, can the freedom and choice agenda be balanced with the need to ensure people are saving enough for their retirement?

“I think it can, we support freedom and choice,” says Wilson.

Robbins is even more positive about the role of freedom and choice as an incentive. “On its own it might lead to people saving more,” he says, though he is quick to warn of the danger of savers misusing the freedoms to spend the money in their funds too quickly.

Many people have withdrawn lump sums – 85,000 according to the Treasury – but the amounts involved have averaged £15,500, too small to make a significant difference to long-term retirement income.­

Convincing savers to put money into a pension pot in the first place is far more important to long-term saving than how they make use of the pension freedoms.

The consultation closes September 30 and will be followed by a summary of responses.

However, any proposals resulting from this will face resistance from an industry already suffering from reform fatigue.

Aries’ Neale says: “The whole thrust of recent pensions legislation has been to disincentivise people from saving.”

For Neale, the most important part of encouraging saving in pension schemes is for the government to stop proposing policies that will increase the legislative burden placed upon pension providers.

In support of this, 79.7 per cent of respondents to Hargreaves Lansdown’s survey believed a stable long-term system would encourage them to save more in a pension scheme.