The pension reforms currently being put in place in the UK are aimed at addressing the unfortunate fact that half of the working population either have inadequate pension savings or no pension savings at all.
The government’s response to this has been to propose a new National Pensions Savings Scheme (also referred to as Personal Accounts) into which millions of employees will be auto-enrolled from 2012 onwards. But the new scheme will be put in place with the current system of means-tested handouts for pensioners left largely in place. The mass provision of means-tested benefits for retired people has the unfortunate effect of making pension savings unsuitable for millions of people in the workforce, but it is not easy for the man or woman in the street to appreciate why.
Late last summer I was quoted in an article in the Guardian newspaper on this subject and ended up in a public debate with the pensions minister, James Purnell, following my comment that the new scheme could effectively lead to people in the target market for the reforms being taxed for saving. The following is an extract from The Department for Work and Pensions’ website in response to that:
‘Some of you may have come across the following article in today’s Guardian. It suggests government plans for a national pension saving scheme are ‘flawed’ and could lead to mis-selling. The piece is both misleading and inaccurate. In particular, I’d like to challenge the notion we’re asking people ‘on low incomes to pay higher rate tax (40 per cent) on savings when they retire’.
‘It is simply untrue to describe Pension Credit as a 40 per cent tax. Under our proposed new system if a pensioner had £100 per week from their state pensions, and £20 per week from their private pension, they typically would end up with an extra £15.50 from Pension Credit. In other words, our proposals mean the vast majority of people will be rewarded for voluntary saving.
I was very pleased to see the minister using a specific example to illustrate why he thought I was wrong and why the government was right. Strangely enough, the minister’s own example actually proved that...he was wrong.
And that is not a matter of opinion — it is a matter of fact. The person chosen to show how the Pension Credit system ‘rewards’ people for saving demonstrates most clearly that the saver is taxed at a rate slightly higher than 40 per cent.
For the record, the way the Pension Credit and Savings Credit system works is as follows:The person in the example is entitled to £100 per week in state pensions and has saved enough in a private pension to buy an extra £20 per week income. Such a person would, as the minister rightly said, qualify for an extra £15.50 per week in Pension Credit.
However, if this person’s next-door neighbour were also entitled to £100 per week in state pensions, but had not bothered to save anything extra in a private pension, they would be treated far more generously by the system of credits. Such a person would receive an income top-up of £14.05 per week through Guarantee Credit and £9.75 per week in Savings Credit. That is a total of £23.80 a week extra.
The person in the minister’s example, then, would get a total weekly pension of £135.50 (£100 + £20 + £15.50), whereas the non-saving next-door neighbour would get a total weekly pension of £123.80 (£100 + £14.05 + £9.75).
So, although the person in the minister’s example has taken the trouble to save enough in a pension scheme to buy himself or herself an extra £20 a week, the Pension Credit system will leave them just £11.70 a week better off than a non-saver. That is slightly more than a 40 per cent tax on saving and is exactly why millions of people on modest earnings should be very wary indeed about this proposal for a National Pensions Savings Scheme.
If the loss of £8.30 in weekly income doesn’t sound much, it is worth reflecting that the typical capital cost of that amount of weekly income for a 65-year-old is around £7,000 today. A £7,000 investment that yields not one penny’s worth of value is rather disastrous investment for anyone to have entered into voluntarily, let alone to having been swept into through the process of auto-enrolment.
The current system of means-tested credits for pensioners taxes savers whether ministers like to hear it described that way or not. My argument, and that of a growing number of people from within the pensions industry, is that such a system makes it very dangerous to launch a national pension scheme utilising automatic enrolment and aimed at medium- to-low earners.
If this ever reaches the statute books there would be a high chance that people could end up thinking they are saving for 100 per cent of a private pension, but in fact only getting 60 per cent of its value. If people were to be made aware of that before they sign up hardly anyone would join.
And that’s the point really; the National Pension Savings Scheme mustn’t be allowed to go through as an ‘advice-free zone’ as some in government are calling for. Consumer protection must be built into it just as it is with our existing pension system.
Strangely enough, the government seems to agree with this and has just launched its new Financial Capability Strategy which is designed to ‘[ensure] that every person, including those on the lowest incomes, can get quick, easy and simple access to good quality financial advice’.
We can only hope that this initiative can yield some tangible results before the launch of the new scheme in 2012 so that people likely to be automatically enrolled into the scheme will by then know enough about the financial facts applicable to it to be able to opt out if they are otherwise likely to receive poor value for money by remaining as contributory members.
It does seem rather perverse, though, that we are about to build a system which may offer such poor value for money to millions of people who will be automatically swept into it with the onus being put on them to opt out if they judge it to be in their best financial interests to do so. If the new Personal Accounts are really so attractive an investment, why not simply make them available and invite people to take part by investing in them?
The problem with a pension system where so many people could be potentially penalised by saving is that no financial adviser would ever recommend that saving for a pension was either suitable or advisable for everybody.
That is where we are with our existing pension products today and that is why many of us in the industry feel that reform is so necessary if we are to have any chance of spreading suitable pension savings to those who are currently excluded from the pension system.
That, of course, would need real reform where everybody, even those on low earnings, could rely on their savings to deliver proper value; but for pensions to be widely and economically distributed they must first be made suitable for all, or protective measures must be put in place to ensure people are always treated fairly.
The consequence of imperfect reform, quite apart from the wasted opportunity of getting things right, could be that the existing pension markets are irreparably damaged by the introduction of an alternative approach to pension saving that, although available at a lower cost than current pension products, could unfortunately for many be an unsuitable and poor value investment.
First published in Parliamentary Brief, February 2007