Pension “auto enrolment” is seen as one of the UK’s big public policy success stories.
Since it was introduced in 2012, employers have been obliged to offer a pension and enrol all eligible staff unless they opt out. Some 9mn more people are now saving (mostly) modest amounts for their pension — the minimum employee contribution is 5 per cent, and 3 per cent for employers — with a low level of opt-out.
It looks like the perfect example of Nobel Prize-winner Richard Thaler’s “nudge theory” of behavioural economics, getting people to make the right decision, without compulsion.
But is auto enrolled pension saving really such a good thing for the 20 per cent of taxpayers — those earning up to £50,000 — that it was designed to help?
Rather than a “nudge”, auto enrolment is really a shove. If people choose to opt out, their overall salary goes down, because they lose the employer contribution. Not much of a choice?
And tax breaks — the only “magic” in pension saving, versus saving outside a pension in an Isa — certainly help 40 and 45 per cent taxpayers, earning over £50,000, but do precious little for 20 per cent taxpayers.
Although pension contributions are tax deductible, pensions in payment are taxed as income, so the only real freebie is the tax-free one-quarter cash lump sum. This reduces the retirement tax rate for 20 per cent taxpayers to 15 per cent — for every £80 after tax pension saving the tax gain is just £5, or 6 per cent of the amount saved.
Meanwhile, 40 per cent taxpayers do much better. For every £60 after tax pension savings, they gain £10, or 17 per cent of their saving. The real winners are those paying 40 per cent tax in work, but only 20 per cent in retirement. For every £60 after tax pension saving their gain is £25, a whopping 40 per cent of their saving.
But it’s a big leap of faith to believe the tax-free lump sum won’t be reduced, or scrapped altogether, over the next few decades.
And, anyway, it’s just a payment for locking up your money for 30 or 40 years, with no way to get your hands on it, if you need it. The economic cost of losing this flexibility is high, especially for lower earners with little or no ready savings.
For the many 20 per cent taxpayers who save into a pension, but also borrow to make ends meet, high interest rates on credit cards or borrowings completely overwhelm their tax benefit. Pension saving costs them real money.
What should happen?
It is standard practice for senior executives to be offered a higher salary for giving up the employer pension contribution (see the remuneration section of any glossy annual report).
This should be extended to all staff, not just the highest paid. Everyone should be able to take cash instead of a pension contribution — pitched to be cost neutral for the company.
Education should replace arm twisting. People can then make a real choice to save in a pension, an Isa — which doesn’t lock-up their money for decades — or avoiding taking on debt, or simply spend it.
A few companies already offer higher pay and no pension contribution — the accountancy firm Deloitte introduced this in 2022, and United Learning, running academy schools, is introducing something along similar lines.
What about tax?
There are rumblings that chancellor Rachel Reeves could use the autumn Budget to raise money by reducing the tax break for 40 per cent taxpayers. This would be a mistake.
Pension tax should be changed, not to raise money, but to encourage 20 per cent taxpayers to save for a half-decent retirement.
The new Labour government should move to a flat rate of tax relief for all pension savers — which Reeves backed in 2016 — set to be neutral for the Treasury at, say, 30 per cent.
A flat rate is fundamentally fair — everyone gets the same tax top-up for each pension pound saved. It is also efficient, encouraging the lower paid to save more for their retirement, and helps close the gender pension gap, which sees men, on average, receive much higher pension income than women.
A flat rate also cuts through the complex rules for the very highest earners — especially NHS consultants. The annual allowance cap could be scrapped, and we could forget about reinstating the lifetime allowance.
Higher earners would simply choose to save as much as they wanted in their pension, taking their less generous tax break into account.
And despite the objections of some experts, the practical mechanics of a flat rate are easy. Pension contributions would include both employer and employee contributions, to avoid “gaming” the system, for example offering higher employer contributions in exchange for a lower salary.
For defined benefit pensions — almost exclusively public sector these days — the value of the annual contribution would be the pension earned in any year multiplied by a “factor” set by the Treasury, just like today. Individual tax codes would be tweaked up or down, so all taxpayers got the correct flat-rate top up.
The new Labour government can make a real change to the retirement of millions of people. It should ignore the howls of protest from 40 and 45 per cent taxpayers, and the pensions industry lobby, and introduce both an AE cash option, and flat rate tax top up.
John Ralfe is an independent pensions consultant. Twitter: @johnralfe1
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