Will the ISA topple the pension?
2015 will no doubt go down as the year of the pension ‘shakeup’. Chancellor George Osborne had already declared his plan for the revolution in 2014, but the impact of the freedoms has been marked. In the first three months after the obligation to annuitise was withdrawn in April, some £2.5 billion in payments were made to savers according to figures from insurers, while it is estimated that £27 million is being withdrawn from pension pots every day.
Suffice it to say, the savings landscape has palpably been altered forever.
Yet the revolution shows no signs of slowing down, as Osborne announced the publication of a green paper at the Summer Budget setting out sweeping reforms regarding the manner in which pension savings are taxed, and HM Treasury are conducting a consultation to explore the possibility of bringing them into line with the tax relief structure of ISAs. The consultation process is effectively looking at three potential options:
i) Creating a new ‘Pension ISA’ as an alternative to the existing pension
ii) Keeping the pension, but offering a flat rate of tax relief
iii) Maintaining the status quo
The first option would be the most radical change of all, and may have some people scratching their heads. However, the simplicity of ISAs has made them immensely popular, and there is growing debate – particularly among basic rate taxpayers - as to whether they should turn to an ISA instead of a pension even in the current climate.
The existing architecture for taxation on pensions is known as EET (Exempt, Exempt, Taxation), which means that tax relief is offered to both contributions and capital growth of the fund, with income only being taxed once it is withdrawn at retirement age. Like the existing ISA, a Pension ISA would remove upfront tax relief (savers make contributions from their taxed income, unlike a pension), but allow fund growth and withdrawals to be tax-free (TEE).
For the Exchequer this would be enormously enticing, as it would provide an advance on tax revenues usually deferred until withdrawal on pensions, and topping up the coffers would give his bid to reduce the fiscal deficit a significant boost.
However, the consultation should, first and foremost, be about the benefits to the saver. Certainly, the simplicity of a Pension ISA would be appealing, and avoiding the notorious insurer fees associated with drawdowns from pensions would add to the appeal. In addition, the ability to access these savings before the age of 55 is another benefit of the proposed overhaul.
Such accessibility could be seen as a blessing and a curse though. Indeed, with pensions currently ring-fenced as they are, succumbing to the temptation of frivolous spending of one’s life savings doesn’t come into the equation, and a retirement nest egg of some sort is essentially guaranteed. The other thing to note is that contributions into pensions still generally yield better lump sum values at retirement age than ISAs.
The case for flat-rate tax relief
The numbers advantage significantly diminishes for basic rate taxpayers though, and this is due to the nature of the current pension tax relief rules. Individuals currently receive upfront tax relief at their marginal rate on contributions, which clearly favours higher earners, who could then, in theory, manage their portfolio such that they are taxed at a lower rate by the time they enter retirement and begin drawing down from their pot.
With the imperative being on incentivising lower earners to save, the case for a flat rate of upfront relief, at a percentage somewhere between the basic rate and higher rate tax bands, has been mooted as a good solution. In simple terms, something like 30% would be a fairer middle ground between higher and lower earners, providing the latter with greater benefit when making contributions.
This would also preserve the existing pension model, and avoid the complexities that would arise by running this concurrently with the Pension ISA system. After all, the introduction of a Pension ISA wouldn’t mean the pension as we know it would suddenly disappear – it would obviously need to run its course for decades to come.
What about just staying as we are?
It should be borne into mind that although pensions are classed as EET, the taxation on withdrawals is, in reality, only a partial taxation given that 25% of each withdrawal is tax-free. In addition, some experts believe that the elimination of an upfront tax break with a Pension ISA would discourage people from saving, given that the long-term benefit of tax-free withdrawal is less tangible than a ‘win’ at the start. To reference that abominable old cliché: A bird in the hand is worth two in the bush.
Yet despite the strong counter-arguments to the Pension ISA, it would also take a brave individual to argue that the pension system in its current form is in fine fettle, and Osborne’s willing to question the gospel and implement changes should be welcomed. Of course, too many radical changes in a short space of time could undermine the credibility of the retirement savings landscape, and may result in savers becoming reluctant to ‘buy in’ to any new system if they suspect everything will just be changed again at the next Budget.
Whatever the result of the consultation, any change that not only encourages saving across the board, but also simplifies things is something we will ultimately champion. We’ll be watching with a keen interest to see which way the Chancellor decides to go.
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