This week I’ve been on a cruise. I can’t recommend it highly enough (as long as you are on the Crystal Serenity – I’ve never been on any other ships). I was giving some talks on investment, so I wasn’t totally relaxed. But everyone else was.
They read, gossiped, played bridge, danced, practised their putting, they went on excursions, complained about the odd excursion (key takeaway: watch out for the donkeys in Santorini) and, when they weren’t doing those things, they ate and drank (a lot) in the sun.
It was gorgeous – the kind of retirement holiday everyone should get to have, but most people won’t get to have. On the plane on the way out I read most of George Akerlof and Robert Shiller’s new book, Phishing for Phools: The Economics of Manipulation and Deception. It has a pretty simple premise: completely free markets somehow force us to make choices that we don’t really want to make. We want to save for our future, but the relentless pressure of the marketing men on our wallets won’t let us. So we spend instead.
Instead of ending up with the 15-hour working week that Keynes promised us back in 1930 (with enough leisure time to give us all nervous breakdowns) we actually spend 35-50 hours a week working in the vague hope that we can satisfy the demands of our consumerism and save enough for a week off on a cruise in our 70s.
A large number of us fail. Successive UK governments have grasped this. And they worry (quite rightly – a population of poverty-stricken old people is a bad look for a developed economy). So they encourage us the best way they know to get us to save for our old age: they pay us to do it.
Stick money into a pension in the UK and you get back every penny of income tax you paid on it. It is tax exempt at the point of saving; tax exempt as it grows (no dividend tax or capital gains tax); and finally taxed when we withdraw it. This is good for 20% taxpayers. But it is particularly fabulous for higher-rate taxpayers for the simple reason that it reverses some of the progressive nature of the UK income tax system. Anyone who felt the 50% rate was a bit unfair before it was cut to 45% simply had to pile cash into a pension (up to the constantly changing limits) to avoid it. They can now do the same with the 45% rate. Easy. Well, easy-ish.
The problem with our system is that it is very expensive – upfront tax relief on pensions is estimated to cost the Treasury about £40bn a year – and it is so complicated that it doesn’t really work that well. Most people barely understand the basics of our tax system, let alone why one lot of people get a £20 top-up for every £80 they put in a pension, while others get £40 or £45.
Or perhaps why some people can have £1.25m in a pension, others can have £1.6m. Or why you have to pay income tax if you withdraw money from your pension pot, but only on 75% of it, but you can pass it all on free of inheritance tax, which somehow (how? why?) makes pension assets different to other assets.
It’s just stupidly complicated. A recent survey from Towers Watson suggested that only a quarter of people feel “very informed” about pensions (about the same amount said they were more concerned about their wrinkles and grey hair than their retirement incomes) – and I suspect half of those are completely wrong.
Quite often, when we don’t understand things we don’t engage with them. It’s the same with pensions. Even with auto-enrolment, most of us aren’t saving enough for a coffee in a café looking out at a cruise ship, let alone to enjoy one on one. And when we do save, we shun pensions for Isas (simple savings vehicles that we all understand): over 20 million people have opened an Isa. Change is needed. But what sort?
The government has just closed (another) consultation on the matter. The result is still up for grabs, but one thing at least is clear: the game is up for higher earners. Whatever the new system is, it will further cut the reliefs given to them. They know what an easy political target they are, of course, and are taking pre-emptive action.
Hargreaves Lansdown reports that pension contributions from higher earners are up 120% this year so far. The question, then, is just whether pensions will be revamped to become a kind of Isa (taxed on the way in but exempt after that) or stay structured as they are with a different kind of tax relief.
If it were up to me, I’d go for a simple expansion of the Isa system. If people weren’t prepared to accept as their incentive the simple promise that their cash, once in, is tax exempt for ever, they wouldn’t use Isas at all. But they do – as their main saving vehicle. This rather suggests to me that a system that was simply “more Isa” would work pretty well.
But I have some good news for you on this. There is no way that it would happen without an upfront incentive. Think about where all that lovely tax relief goes – I’d guess that 90% of it goes directly into one investment fund or another. So if the total relief adds up to £40bn a year, and we assume that the industry as a whole (including the brokers etc) takes 1% of that (it’s probably more), we’re talking £400m to them upfront every year.
The financial industry isn’t going to let that go in a hurry – which is why almost all the professionals I talk to insist that a new system that involved Isa-style pension accounts couldn’t possibly work unless savers were given an incentive of at least 50p in the pound. This is nonsense. On the other hand, the industry’s flat refusal to contemplate the full scale removal of lovely industry subsidies (for that is what they are) does at least work in savers’ favour.
That makes a pleasant change, and means that we will probably end up with an incentive worth in the region of 30p in the pound. I predict it will not be called a tax relief (no one understands this) but a top-up (everyone understands this). It will cost more than it should, but it will at least be simpler.
In the meantime, there is one clear message here for higher-rate taxpayers: use it or lose it. From next year, the allowance will fall for those earning over £150,000; by the time they are making £210,000, it will be down to a mere £10,000.
However, the chancellor has taken a little of the sting out of this for us: in his last Budget he restarted the clock. From the day of the Budget everyone got another £40,000, so if you had front-loaded you could shove in another £40,000. You can also carry forward unused allowances from the previous three years. Now is a really good time to do that.
• This article was first published in the Financial Times