Financial Adviser feature on failure of Government policy to encourage savings
by Dr. Ros Altmann
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The Government and pensions industry are concerned about the lack of private pension coverage in the UK. The Pensions Commission Report highlights the dramatic decline in contributions into final salary schemes and the sharp reduction in contributions, when a company switches to a money purchase scheme instead. If Government is really serious about wanting to encourage more people to contribute to pensions, a radical re-think of its policy approach seems to be called for.
So far, there have been several policy initiatives, apparently designed to try to extend the coverage of pensions to those who are missing out in the current system. In particular, lower and middle income groups, women and part-time workers. There have been numerous reviews, Green Papers and consultations and we have a Pensions Bill going through Parliament. The principal policy measures to encourage private pensions have been the introduction of Stakeholder Pensions and the Informed Choice initiative. Everyone, except the Government, can see that Stakeholder pensions have failed to extend pension coverage to the target group of lower and middle earners. Over 80% of company stakeholder schemes are empty shells and new contributions into stakeholder pensions have declined. As regards the Informed Choice agenda, many people have received decision trees, leaflets. Statutory Money Purchase Illustrations and trials of Combined Pension forecasts are underway, but these initiatives are simply not sufficient to achieve the stated aims.
The policy changes so far are all ‘supply side’ measures. Offering cheaper, simpler products, clearer information and better disclosure, encouraging the use of decision trees and generic advice. But the real problem lies on the demand side and measures have not yet been put in place to address this. If people do not want to contribute to pensions (and, in general, they don’t) then however cheap and simple the product is and however much information they receive, they will not engage in the process because they don’t want to.
There are so many barriers to pensions at the moment and, unless measures are introduced to address the lack of demand for pensions, the Government’s reforms are unlikely to work. Indeed, despite the many supply side improvements which have been made, there are still supply issues which need to be overcome. The complexity of application procedures, reams of paperwork, key features documents, money laundering requirements and so on, mean that the application process for pensions is still very complex. It is much easier for people to take out a £20,000 loan that they cannot afford, than to put £20 a month into a stakeholder pension.
What is particularly lacking in all the recent reforms is the introduction of new incentives to contribute to a pension. The only incentive we have, at the moment, is tax relief and this is targeted at the upper income groups. Tax relief for pensions is a pretty good incentive for those who pay higher rate tax (about 10% of taxpayers) but is not much of an incentive for the mass market.
For every £3 that a higher rate taxpayer contributes to a pension, the Government adds another £2 (and only part of this has to go into the pension, the rest is a ‘cash back’ saving on their tax bill). For every £3 which those who pay basic rate tax contribute, the Government puts another 85p into their pension. People who do not have much discretionary income, who are nervous about locking their money away for decades without any emergency access to it, who do not want to think about getting old, do not like the idea of buying an annuity and would just rather spend the money today, this is hardly much of an incentive. Add to this the possibility that, when they retire, the Government might penalise their private pension income by at least 40% if they are among the three quarters of pensioners who will be entitled to pension credit, and it is hardly surprising that most people do not find basic rate tax relief enough of an incentive. We spend over £10 billion a year on this incentive for pension contributions, but over half of this spending is on top rate taxpayers. This seems such a waste of scarce resources. Surely, top earners would be most likely to save anyway, while those who really need the most incentive to save are receiving the least. In addition, most people do not understand how tax relief works anyway. Some apparently even think that tax relief is something negative, because anything with the word ‘tax’ must be bad.
We need to take the incentive mechanism outside the tax system altogether and perhaps move to a system of matching payments. I would recommend that everyone should receive the same incentive for the same amount of pension contributions. For example, giving everyone the equivalent of higher rate tax relief, so that for every £3 anyone puts into their pension (up to some limit) they receive another £2 from the taxpayer. For most people, this would be much easier to understand and a far more powerful incentive than tax relief.
Tax relief is unfair, illogical, inefficient and regressive. It is sometimes argued that tax relief is fair, because there is relief on the contributions, but then the pension itself is taxed. Unfortunately, this is not really the case because there are so many ‘leakages’ in the system. First of all, there is the 25% tax free lump sum. Secondly, only 2% of pensioners pay higher rate tax, and all pensioners have a higher personal allowance, so there is significant tax arbitrage. Also, higher rate tax relief is received on the entire amount of any pension contributions, but only the highest marginal slice of pension income is taxed at top rate. In practice, the tax relief system targets huge amounts of public spending on people who require little incentive to save and this is at the expense of those who society really needs to encourage, who are not currently receiving enough incentive.
There may also be other ways of encouraging demand for pensions. One ‘demand side’ initiative might be to introduce a lottery for stakeholder pensions. For example, every £1 contributed to a stakeholder pension each week might carry an entitlement to enter a lottery to win £1million every week. This could perhaps encourage younger people to think there may be something in a pension for them today, not just when they retire. A system of prizes, possibly rather like National Savings Premium Bonds, might encourage younger people to put, say, £10 a week into a pension, rather than buying lottery tickets. A prize of £1 million a week would cost just £56million a year, which compares favourably with the cost of a nationwide advertising campaign to encourage awareness of stakeholder pensions – and is likely to be rather more effective.
Employers also need better incentives, if they are to be encouraged to provide pensions for their workforce. At the moment, employers are pulling back from providing pensions and contributions are being cut. Finance Directors are concluding that pensions are a company ‘cost’, rather than a company ‘benefit’. They are not convinced that spending money on pensions will deliver good returns, in terms of staff retention and higher quality. Particularly employers in smaller companies may be trying to discourage staff from contributing to pensions, since this means higher costs for employers who have promised to match employees’ contributions. Improved employer incentives may be required, perhaps with much lower tax or national insurance for those who provide good pensions.
In summary, the Government’s policies so far have failed to encourage pension contributions by those not contributing at the moment. The problem is not merely on the supply side (i.e. lack of information, consumer confusion and product complexity) but is actually on the demand side (i.e. most people do not want to put money into a pension). In addition, the pension credit has placed new disincentives in the way. The Government must recognise the loss of confidence in pensions, lack of trust, and difficulty most people have with committing money to saving over the long term, rather than spending over the short term. Far better incentives are needed, to help encourage demand for pensions. Even if the disincentive of pension credit is removed, there are not adequate incentives to encourage either individuals or employers to contribute to pensions. Radical action is required.