PENSIONS

Must it be compulsion or tax relief, can pension provision be built on a combination of the two? This is a key question prompted by the politicians’ latter day realisation that a lack of pension provision is a looming problem here in the UK as well as within the rest of Europe. The problem does not simply feature on the actuarial horizon for the middle of the next decade, the real crisis will come in the next 10 or 20 years.

Although the state scheme has shrunk in terms of the proportion of national average earnings which the basic state pension represents, many retiring now are having that basic state pension supplemented by a fairly hefty level of SERPS. For someone on average earnings with a full entitlement to both the basic state pension and SERPS, the state is currently paying out a benefit of around 50% of pre-retirement net earnings from work.

State benefits of this level are unprecedented in the UK.

A better than ever state pension is only half the story, at least for half the working population. Around 50% of the workforce is currently in an occupational pension scheme. Those who are retiring from such schemes now have probably completed many years of pensionable service. They have a retirement benefit which reflects that service and earnings at or near retirement which have been influenced by the inflation of earlier decades and the substantial real increases in gross pay which many have enjoyed during the past few years. Official figures showing the average amount of occupational pension paid to each recipient are misleading. These figures include the present value of pensions that may have been paid out for many years. The amounts being drawn by those who are retiring today are much more substantial. What is more, many of these benefits will receive further boosts from guaranteed increases set at a level which, in low inflationary times, hold out the prospect of complete price protection.

The story does not end here. Many of those entering the world of retirement can also lay their hands on money accumulating in PEPs and TESSAs, the proceeds of building society and insurance company demutualisation together with the odd windfall inheritance from parents who themselves may have benefited from the property boom if not from generous pensions. There is a general acceptance, at least among the chattering classes, that this utopia cannot last forever. Where they have it wrong, however, is believing the crisis will hit midway through the next century.

The real value of state benefits is eroding quite quickly. Those who retire in the next decade or so will receive a much less substantial benefit than is possible today. While occupational pension schemes have an awful lot going for them in theory, this theory is not being put into practice as much now as it was in earlier decades. Some employers are withdrawing from pension provision while others are scaling down that which they may continue to offer. Personal pensions are as yet no substitute since relatively few who should actually take them out, do so, and those who do, have a starry-eyed view about the extent to which small payments in will be converted into big benefits out. The profits of demutualisation are a passing phenomena and elderly relatives who die in the coming years may have used up much of their wealth in financing their own retirement or paying for the care which neither state nor family may be quite so willing to dispense in the future.

There are few votes in telling people there are problems around the corner and although they can be solved, most solutions are expensive, so politicians are focussing our attention on the year 2040 and beyond. In so doing, they raise both the question of compulsion and the tax regime that should apply to both the accumulation and payout of pension entitlement. While one can have a philosophical debate about the place of compulsion in our society, it is a prerequisite of ensuring all of us make adequate pension provision. While politicians are currently toying with the idea of greater compulsion, the level of compulsion so far suggested is woefully inadequate if realistic retirement benefits are our objective. If the price that has to be paid for any compulsion is an undermining of the tax regime that applies to pensions, the price could be too high and the policy switch counterproductive.

The current tax regime is described as EET. This means while contributions and investment income are tax exempt, the emerging benefits will be taxed as income. Politicians in all the parties are currently testing the water for a switch to TEE. In tabloid shorthand, this involves the application of the PEP regime to pension schemes.

The Treasury may find such a switch attractive since it has positive cashflow implications for those ministers whose real concern is the balancing of the books this year and next. While the current tax regime does not involve tax avoidance, it does provide for a deferral of a tax liability that unquestionably has an impact on the Treasury’s short-term cashflow.

If the pensions tax regime were to be reversed, there could be adverse effects in both the short and long term. In the short term, people may change their behaviour in a way which will reduce the positive cashflow benefits on which the Treasury might be counting. In the long term, great damage could be done if a change of tax regime, coupled with inadequate compulsion, meant people made less pension provision in the future than they make now. Do you really believe politicians who say that, in return for a loss of tax relief in the short-term benefits that will be paid out in 30 or 40 years time will not suffer a second tax charge? While the politicians who make such promises today may be well meaning, they have a naive view of the integrity of their successors.

The present pensions tax regime is basically sound although in need of drastic simplification. Such a simplification should be applied to pension regulations that emerge from other government departments in addition to the Treasury. Such a simplification may create an environment in which employers and employees voluntarily fill the pensions gap which would otherwise emerge in the next 20 years. They may be willing to accept greater compulsion too so long as we are all in the same boat, thereby preventing pensions-conscious employers being placed at a disadvantage. A tax regime which makes compulsory pension accumulation palatable and extra voluntary provision attractive is a very clever ruse on the part of politicians who know that pension income will ultimately be subject to tax.

Alan Pickering is senior pensions consultant at Watson Wyatt.