What is the point of providing tax relief on pension contributions? The usual answer is that we want to encourage people to save for their old age. That’s true of course, but what we rarely ask is why we want to do this.
You might say that it is because we want to encourage them not to overspend on their present at the expense of their future; that we want to be sure people have a satisfying retirement; or that it is one of the marks of a civilised society that a working life ends in a degree of comfort.
But from the point of view of the government (and the taxpayer), that’s not it at all. We want to make people save now so that we don’t have to pay them too much in the way of welfare later. Look at it that way, and our pension tax relief system makes absolutely no sense.
Why? Because we’re letting people save far too much. How much does a pensioner need to survive without the help of the state? One answer might be: the same amount as the minimum wage. I’d say that’s pretty mean. Working full time (40 hours a week with no holidays) on the minimum wage would bring in not much more than £11,000 a year – not a sum that we can realistically pretend is a pleasant living wage these days.
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So let’s say £15,000. That’s still a bit mean but, added to the basic state pension – another £5,077.80 – it’s definitely enough to live on. But if £15,000 a year is enough to shift financial responsibility from the state to the individual, why on earth are we subsidising people to save more?
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Right now you can, one way or another, have a total of £1.8m (the current “lifetime limit”) in a pension fund. Even if you assume that you can earn only 3% on that, it still provides an income of about £54,000 – and that’s without running down the capital.
The last Labour government attempted to cut back on pension tax relief for the better-off with a system whereby tax relief tapers off after a worker earns more than £130,000. But this is to entirely miss the point. How much someone earns has very little bearing on how much they are able to save. Someone earning £50,000 but living in Northumberland with no children is going to be able to put aside a lot more than someone on £150,000 living in London with four children. By introducing tapered tax relief from £130,000, you might be punishing the latter for his lifestyle choices, but you aren’t doing much to prevent him becoming a burden on the state in his old age.
It would be far better, surely, to apply limits not to the amount a person earns but to the amount they actually put in a pension. How? By simply setting a limit on how much can be contributed in any one year. This isn’t an entirely new idea. The industry – by which I mean independent financial advisers and pension fund managers – has already begun to lobby for it.
But when they do so, they also miss the point – suggesting, as they do, a pension contribution cap of about £50,000 a year. That’s too high. Let’s say you save £50,000 a year (after your tax relief has been added back in at whatever your marginal tax rate is) for 20 years and it grows at 3% a year. You’ll end up with a pot of almost £1.4m. And the income from that? Stick with 3% and it is £42,000 – way more than the government needs it to be and way more than the taxpayer should have to subsidise.
So what’s a more realistic annual limit? I’d say about £20,000. Twenty years of saving – again at 3% and you’d end up with a pot of about £550,000. Income from that at 3% is £16,500 – which is about right.
I’ve tried to make these numbers both very simple and very conservative. I’ve assumed no-one starts saving until they are 40. I’ve stuck with 3% as a reasonable long term total return. I’ve assumed no capital at all is spent in retirement. And I haven’t included the complications of indexing the annual limit to inflation.
But, even so, you can see the advantages. It isn’t going to affect very many people – 90% of pension funds have less than £50,000 in them. It will make the pension-saving system exceptionally simple and transparent. It will encourage people to save just enough to prevent them being a burden to the taxpayer but not subsidise them doing more than that. And, of course, it will save us money.
How much money? Hargreaves Lansdown says that putting in place a £50,000 limit – which is what it is lobbying for – will save us £3.6bn a year. That’s about the same as Labour hoped to save by putting in place its ludicrously tortuous taper relief idea. So cutting it to £20,000 will save rather more. If I were George Osborne, I’d be putting this pretty near the top of my emergency budget list.