Pensions Bill misses the point

The changes to the current pension system in the Pensions Bill, including Personal Accounts, will not make a fundamental difference to pension saving rates, says Chris Gilchrist of EveryInvestor.

“The incentives for basic rate taxpayers are simply too low to motivate them to save in pension schemes,” he says.

Ignoring differences in investment growth or annuity rates, the pension tax incentives are worth just 6.25% for a basic rate taxpayer*.

“The real issue for pension savings is providing basic rate taxpayers with meaningful incentives, an issue the Pensions Bill simply does not address,” says Gilchrist.

“When you add the lack of control and inheritability of pension funds to the poor current financial incentive, it is obvious why most basic rate taxpayers do not save significant sums in pension plans and- in the absence of matching employer contributions- they are generally right not to do so.”

Analysts might question why the financial services industry has not made this point more forcibly to the Government. Gilchrist says the answer is obvious. “Financial services product providers and advisers sell large quantities of pension investment to higher rate taxpayers. With 40% tax relief on contributions and (usually) 20% tax on income withdrawn, this is effective for the saver and lucrative for the product providers.”

Switching from the current form of tax relief to a contribution-matching system (successfully trialled in the Savings Gateway pilot) would involve reducing incentives for higher rate taxpayers and increasing them for lower-income savers. But with the bulk of 2007’s estimated £20 billion of lump-sum personal pension contributions likely to be paid by higher-rate taxpayers, this is a solution the financial services industry is unlikely to endorse.

“Under the current incentive system, we can be sure that a well-off minority will continue to use pension saving schemes for their tax breaks and the rest of the population will use other forms of saving- if they save at all.”

*A net investment of £100 in a pension plan produces a gross investment for a basic rate taxpayer of £125 at the new basic income tax rate of 20%. If 25% of the £125 fund is taken as tax-free cash (£31.25), the remaining £93.75 will all bear income tax at 20% as it is converted into income, leaving a net £75. Added to the tax-free cash, this produces a net £106.25, compared with a net £100 that would be accumulated in an ISA.

This analysis removes the effects of assumptions regarding the conversion of capital into income via an annuity- assumptions it is unrealistic to make when looking ahead 20 years or more.

The only assumptions involved are that both the pension fund and ISA remain tax-exempt, that both pension fund and ISA earn the same net rate of return, that 25% of the pension fund can be taken as tax-free cash, and that the saver pays basic rate income tax in retirement.