Due to the ongoing shift from defined benefit (DB) to defined contribution (DC) pensions, some people argue that changes to pensions policy are necessary because younger generations may not enjoy a similar retirement to their predecessors.
According to the Intergenerational Commission’s report – A New Generational Contract: The final report of the Intergenerational Commission published on 8 May, the crucial difference between current and future retirees is the “sheer scale of risk” that future pensioners are being asked to shoulder.
It states that for this reason, pension policies need to be “built on”. But how far should this go?
Tax relief
The commission – which was convened by the Resolution Foundation to address intergenerational issues – suggests providing a flat rate of income tax relief at 28% on pension contributions to ensure they attract the same rate of tax relief regardless of earnings.
Smart Pension head of pension markets Tim Phillips says he has never been a fan of a flat rate on pensions tax relief.
“A person’s stance on this often centres on whether they see the tax position on pension contributions as a tax incentive or a tax deferral.”
The current ‘net-pay’ tax relief system means that every time a pension contribution is paid it has an income tax exemption at that individual’s marginal rate of tax.
Phillips adds that this is actually a really simple system and is very easy for savers to understand.
“The report bases the 28% flat-rate proposal on the concept that higher-rate taxpayers could get tax relief at 40% but then retire on a lower income and only pay 20% on their earnings in retirement.
“But for millennials, for example, retirement is so far away that it wouldn’t be possible to speculate on what sort of income tax rates will be prevailing in 30 to 40 years’ time.”
The commission further proposed a new cap of £42,000 on the size of tax-free lump sums taken at retirement and allowing relief on employee National Insurance contributions (NICs) for pension contributions to “further support progress among occupational pension savings among low-earners”.
Low-earners in this scenario are those earning below the median age income for their generation. The lowest earners are in the bottom 20th percentile.
Hargreaves Lansdown head of policy Tom McPhail says there is unfinished business here, and a flat rate of relief may well be the answer on NICs.
“However, capping tax-free lump sums at £42,000 would undermine confidence in pensions,” he adds. “Reform of pension taxation needs to be done in a measured, holistic way; one of George Osborne’s greatest failures was to give up on the reform process he initiated back in 2015.
“There are strong arguments for a more generous incentive with a lower annual cap and the abolition of the lifetime allowance.”
Under the current system, members can take 25% of tax-free cash out of the total amount in their pension pot at retirement.
Another proposal laid out by the commission was to extend NICs to the earnings and occupational pensions of those above the state pension age (SPA). The SPA is currently 65, but the government confirmed last year that this will rise to 68 between 2037 and 2039.
Royal London director of policy Steve Webb says: “Applying NICs to occupational pensions in payment would leave pensioners with a significantly reduced disposable income; for those close to retirement it would be too late to save more to make up for this shortfall.”
The report also suggests raising the value of the new state pension, relative to ‘median earnings’, and replacing the triple lock with a new ‘double lock’.
Phillips supports the idea of removing the triple lock, calling it a “particularly egregious example of a policy that arbitrarily widens the generational divide”.
“The formula is pretty bizarre and guarantees that over time this element of the recipient’s income will outstrip both price and earnings inflation. That just doesn’t feel right,” he adds.
The existing system guarantees that the basic state pension will increase each year by whichever is the largest of inflation, average earnings, or 2.5%, while a double lock would remove the 2.5% minimum annual rise.
Auto-enrolment
In addition, the commission argues that the scope of auto-enrolment (AE) must be expanded by enrolling workers on more than £6,000 per year, and to level up employer pension contributions to match those of employees.
Phillips says: “This feels like an eminently sensible way to help engender a savings culture with more people. The auto-enrolment trigger was broken from the income tax personal allowance several years ago. The £6,000 threshold would get more people habitually saving, and that has to be a good thing.”
The current AE threshold is £10,000. With only earnings between £6,032 and £46,350 pensionable.
But if a £6,000 threshold implemented, the changes could add significant additional costs to employers.
Webb explains how this would happen: “This would include a higher mandatory rate of contributions under AE; the loss of higher rate tax relief on employer contributions into workplace pensions; a duty to enrol workers earning between £6,000 and £10,000 into pensions and a duty to make pension contributions when using the services of the self-employed.”
Contribution rates have risen to a total of 5%, with a minimum 3% employee contribution. Next April this will rise to a total of 8%, with a 5% minimum employee contribution.
The commission’s report also looks at how to bring the self-employed into the pensions system. It suggests firms should be required to contract self-employed labour to make pension contributions.
“The first step is to give individuals choice of which pension provider their contributions are paid to,” says McPhail. “This would pave the way for the commission’s proposal for employers to make contributions for contracted self-employed labour.
“Once individuals ‘own’ their retirement savings, getting an employer contribution as well would make all the difference.”
The current AE threshold is £10,000, with only earnings between £6,032 and £46,350 pensionable.
Additional proposals
The report also outlines its support for the development of collective defined contribution (CDC) schemes.
McPhail argues: “The supporters of CDC pensions seem to take pleasure in supporting a slightly abstruse solution in which hardly anyone else has any interest.
“Most importantly, with the exception of Royal Mail, no employers yet seem interested in coming out to play. Let’s wait and see what happens with Royal Mail before devoting further energy to the CDC market.”
Royal Mail and the Communication Workers Union are working towards introducing a CDC scheme for all employees.
The commission also proposes reforming the pension freedoms to offer pensioners protection from the uncertainty of how long they will live by including the default option of a guaranteed income product purchased at the age of 80.
However, McPhail pointed out that while great in theory, no-one is offering these deferred annuity products, because “no-one wants to buy one.”
Mixed bag
Overall, this is a great report, according to Phillips.
“It’s terrific to see issues like this brought together, leading to some bold recommendations.
“It’s absolutely correct that there is a generational divide in pension scheme membership, so it’s great to see such a well-structured report addressing this head-on.”
However, McPhail says “this is a very mixed bag of reform proposals, and given the current government’s limited capacity to act, very little is likely to be implemented during this parliament.”
That said, political parties have a tendency to ‘cherry pick’ policy proposals from reports of this nature, so, “we may find that some of the ideas in this report find their way into policy sooner or later,” Webb points out.
The report also does not address the intergenerational divide between public and private sector workers.
Phillips agrees, and says: “We have a situation in which someone leaving university today can be choosing between work in the public or the private sector and will either be getting a lifetime of DB saving or DC saving.”