Almost Joined-Up Thinking

As an unwelcome distraction from the Malaysian airliner mystery, George Osborne delivered his fifth Budget on March 19. For once, however, a Budget actually contained radical and innovative changes. The annual limit for an ISA, the UK’s tax-exempt investment wrapper, will increase from £11,520 to £15,000, and you will be able to use this entirely for cash deposits instead of only half. More significantly, Osborne has abolished the obligation on retirees to use their pension funds to purchase an annuity, allowing them to access their accumulated capital directly.

This is indeed the biggest shake-up to pensions since the 1920s.  And lobbyists were quite correct that pensioners have been suffering. Because interest rates are low and people are living longer the annuity income from even a large pension pot has been derisory. Much better to permit pensioners to choose how to extract their money, and charge them standard income tax instead of the ridiculously punitive 55 per cent rate on “excessive” lump-sum payments bequeathed by Gordon Brown.

But — and you could sense there was a “but” coming — Osborne has missed a trick.

In 2011 I wrote a paper for the Social Affairs Unit called “The Price of Promises”. Since the UK faces a demographic pensions crisis, and its citizens persistently under-save for their future, I advocated amalgamating the plethora of tax-favoured schemes into a single Retirement Investment Tax-exempt Account or RITA. Savers could contribute up to £48,000 per year, and employers could contribute a further £48,000, receiving tax relief at basic rate and tax exemption for the accumulated fund. They could withdraw up to £25,000 per annum free of tax and face no requirement to purchase an annuity. Unused funds would be exempt from inheritance tax on death, so that savers could share the proceeds of their thrift with their heirs. 

Rationalising the schemes on offer, and removing their complex restrictions, should lower management costs and hence boost returns.

Furthermore, if the official retirement age were raised to 70 by 2034, and the government made an initial seed contribution to each RITA, we could phase out the various forms of state pension as well (through a reassuringly complicated transitional process I outlined in the December 2012 issue of Standpoint) and avoid bankruptcy for the public finances.

The UK is stumbling into this solution by accident.  Since 2010 the annual limit on pension contributions has fallen to £40,000 from £255,000, and the annuity rule has now been abolished, while the ISA limit has gone up to £15,000 from £10,200, with cash and stocks-and-shares ISAs being amalgamated. The current government also intends to rationalise the state pension into a single payment at a flat rate and increase the age at which it can be drawn to 67 by 2028.

However, you will be astonished to learn, the Coalition has not been following a carefully considered plan for personal investment and retirement. The motive has been to cut the immediate public deficit. So the level of pension investment, and therefore the cost of tax relief, has come down. Enabling retirees to access more of their pension pots earlier brings larger sums into income tax much sooner. The whole package sounds generous but, over the period for which the Treasury scores these things, it will actually raise taxes by nearly £2 billion net. Today’s deficit is being reduced at the cost of lower tax receipts in the future, just when the demographic crisis bites.

The official reason for the annuity rule was overtly paternalist.  If pensioners were not forced to convert their funds into a regular income stream they might blow all their money quickly (on, perhaps, bingo?) and be left to rely on the welfare state.  Unofficially, the Treasury wanted to claw back cash by converting exempt funds into taxable income. Neither was a good reason for locking up someone’s lifetime savings.

The real flaws with pensions remain: you still have to wait 30 years before getting your money back, and the compliance rules make them expensive to run (especially for institutions that have just lost the revenue from selling annuities). So pensions are still unattractive for twentysomethings, exactly the people we need to encourage to save for their retirement.

Perhaps they will opt for ISAs instead? The increased flexibility is to be welcomed. However the new higher limit does little more than repair the effect of inflation on the pre-ISA limits for Personal Equity Plans from the 1990s.  The average amount invested in an ISA is around £4,000 per annum. That isn’t going to triple, and employers cannot contribute. You have to have something to save before you can take advantage of these changes. Tax relief, which ISAs do not offer, would help contributions go farther.

The demographic timebomb is still ticking.

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