Michael Johnson: pension ISAs are the most effective way forward

Suggested Treasury pension reforms are needed to end unaffordable tax arbitrage

Michael Johnson comments: 

“Recent media announcements indicating that the Chancellor is preparing to announce “pensions ISAs” in his Budget later this month are, of course, speculative.  But, coupled with an up-front “bonus”, it would mean the end of tax relief on pensions contributions. Hopefully, this will come to pass.

Retaining any form of pension tax relief is incompatible with pensions’ “freedom and choice”, which ended any requirement to annuitise (from April 2015).  The Treasury is today exposed to an unaffordable tax arbitrage, as those approaching the age of 55 flip existing savings into pension pots to collect tax relief, only to then take out the 25% tax-free lump sum at 55 and draw down the other 75% in a controlled manner, over time, thereby minimising their tax liability.  The Treasury will never recoup most of its investment in what is supposed to encourage long-term saving.  Higher rate tax relief, in particular, is an utterly ineffective use of taxpayers’ funds.

Introducing the pension ISA would therefore be an act of fiscal responsibility.  With an unsustainably high budget deficit, it would boost the effectiveness with which the Treasury uses taxpayers’ money. If the bonus were 25%, say, rather than the mooted 20%, it would be redistributive too.  Basic rate taxpayers (84% of the workforce) would then receive 33p for every post-tax £1 saved, rather than today’s 25p: the incentive would then be targeted more towards those who most need it.

A more tricky decision concerns the annual allowance, currently £40,000.  Left as is, with a 20% bonus, it would leave the Chancellor with scope to reallocated perhaps £10 billion a year towards reducing the deficit.  Deficit reduction is important.  We have to stop perpetrating intergenerational injustice by adding to the debt mountain: it is the young who will have to service it.

A lower allowance would increase the saving to the Treasury.  Indeed, a limit of £10,000 would be enough for over 90% of the population (perhaps with a ten year carry-forward of unused allowance), and the other 10% save anyway.  But lowering the allowance would create additional pressure on defined benefit (DB) pension schemes.  With the private sector rapidly becoming a DB desert for new entrants, this issue is becoming synonymous with public service pensions.  The Chancellor could choose to duck this for now (by retaining the £40,000 allowance).  Alternatively, a lowered allowance would force the issue. This should be encouraged.

These reforms would also be an example of political leadership, requiring the Chancellor to face down many vested interests, notably the industry, the wealthy and those unions with high levels of public sector workers.  Inevitably, public service pensions will have to move onto a defined contribution (DC) basis, perhaps via an interim period of cash balance schemes.”

Next week, anticipating the Budget, the Centre for Policy Studies will publish a paper intended to address a key question that always arises in ISA-centric conversation.  What of DB in a TEE world?

  1. Michael Johnson’s most recent paper for the Centre for Policy Studies is The 2016 Budget: Pensions. This described a Lifetime ISA (referred to by the media as a pension ISA) to replace personal pensions, with a workplace ISA (to be incorporated within the auto-enrolment framework) replacing occupational provision.

Date Added: Saturday 5th March 2016