As we gear up to a general election there is, as always, a strong smell of vote-grabbing in the air. The current government’s pension reforms in this year’s Budget have given choice and much needed flexibility to a system that was arguably past its sell by date.
Labour, on the other hand, said it will abolish higher rate tax relief on pensions for anyone earning over £150,000 if they win the next election.
One could argue the merits and disadvantages of both approaches. The Budget reforms firmly hand the responsibility of how to create sustainable lifetime income in retirement back to individuals.
But without proper guidance and advice on what to do with pension savings, we could end up with a whole host of problems further down the line. Labour’s approach to remove higher rate tax relief for high earners and use the proceeds to fund employment opportunities for the under-25s sounds like a good reallocation of diminishing government financial resources. Plus, why should those earning high salaries receive more tax relief than others?
Good election grabbing headlines. But the problem with setting a figure of £150,000 for the removal of higher rate tax relief is that it is not a disincentive for the real ‘fat cats’ who earn millions. Let us not forget that the really rich have the capacity to structure their finances in a way that makes little difference to the performance of their retirement savings. But there are others in the workforce currently earning £150,000 who will feel the pinch of removing higher rate tax relief on pensions. Plus, there are a much greater number of workers just under the radar who, in a few years’ time, will also hit this threshold. These are not the ‘fat cats’ earning big City bonuses we have come to associate with higher rate earners, these are people in the public sector and in many businesses up and down the country propping up much needed economic growth in the UK.
Nor does Labour’s approach make any direct financial difference to those on the basic rate of tax. Indirectly, the financial benefits of taking the savings made from abolishing higher rate tax relief on pensions and ploughing it into youth employment are noble sentiments. But for those of us who remember the old Youth Training Scheme, noble sentiments often equate to a waste of money if not thoroughly thought through.
In addition, any savings made from abolishing higher-rate tax relief do not take into account the complexity and often immense cost of implementing changes to the system by the government and businesses alike. Any company currently going through the process of auto-enrolment will certainly testify to the cost and disruption of implementing pension reforms.
But we also need to consider a more fundamental approach to how reform and tax changes impact the value of saving generally. Having different bands of tax relief based on earnings or penalising individuals for wanting to put more money into their pension pots through reducing the lifetime allowance to £1.25m do little to help the overall ethos of long term savings. Indeed, while £1.25m sounds a large sum, for those whose retirement portfolios enjoy an investment growth spurt or are future high earners it will not be too difficult a sum to breach, particularly if the allowance is reduced further.
This theory is backed up by a Pensions Policy Institute report last year that points out that recent reforms have not increased the value of saving for any individuals. The PPI suggests more radical solutions are needed, such as a single rate of tax relief of 30 per cent applied to all pension contributions. This, they say, would not only have a cost similar to the current system, but it would spread the advantages of tax relief more evenly. Also, if presented clearly it could give a large incentive to basic rate taxpayers to save, while still leaving pension saving at least tax neutral for higher rate taxpayers.
While such a suggestion is not without implementation problems, it presents a more positive solution needed to galvanize and encourage long term saving habits in the UK that have been in steady decline for the past 20 years. And with the average pension fund at retirement less than £40,000 and an ageing population who are living much longer, it does not take a maths genius to work out that we have a crisis on our hands.
But in order to restore a long term savings culture in the UK, we first need to tackle negative attitudes to saving which stem from a long-standing lack of faith in the pension system. For far too long life companies have been allowed to destroy any value in pensions with opaque and costly products, with little emphasis on investment performance. At retirement these companies have paid lip service to regulators and peddled poor value annuity rates to policyholders.
Recent pension reforms will go some way to help make saving for retirement a more positive experience. The ability to unlock pensions and put the proceeds into better-performing investment vehicles is also going to help clients to take more control and, hopefully, foster interest in saving for retirement. We know that clients are more likely to spend time mulling over an extra 0.25 per cent in their Cash Isa than getting to grips with their pension statements, so making pensions more investment-focused can only help.
Unfortunately, with an election on the horizon, we can expect a step up in politically motivated changes to pensions and advisers will need to ensure these are factored in to clients’ financial plans, whichever party is in power come May 2015. At present, these include the risk and tax consequences of phased drawdown, which in turn needs to be balanced against the possibility of some future restrictions being introduced on taking out a tax-free lump sum. The threat of removing higher rate tax relief should also act as a prompt for some clients to maximise their pension contributions now in order to make the most of current tax advantages. Importantly, gaining a thorough understanding of a client’s financial position will highlight any disadvantages from suggested changes to pensions, particularly for those clients close to any tax thresholds or contribution limits.
Going forward, we need to work on a simplified and more transparent pension system that provides a positive environment to encourage long term savings for all. In such an environment, political motivation has no part to play if we are to succeed.
Austin Broad is technical director of AFH Wealth Management