Defined Benefit pension deficits increased to £127bn as at 31 March 2015 – Yields on AA Corporate fell back again during March reversing part of the strong increase during February.
Mercer’s Pensions Risk Survey data shows that the accounting deficit of defined benefit (DB) pension schemes for the UK’s largest 350 companies has increased over March from £116bn at 27 February 2015 to £127bn at 31 March 2015. The funding level fell slightly from 84 percent to 83 percent, with the deterioration being driven by an increase in liability values. This was the result of a fall in corporate bond yields and some deterioration in equity markets over the month. At 31 March 2015, asset values were £629bn (representing an increase of £7bn compared to the corresponding figure of £622bn as at 27 February 2015), and liability values were £756bn (representing an increase of £18bn compared to the corresponding figure of £738bn at 27 February 2015).
“Bond yields fell back again in March reversing some of the rise in yields seen during February which had provided what seems like a rare period of good news at that time,” said Ali Tayyebi, Senior Partner in Mercer’s Retirement business. “This means deficits have increased to near their record high, and the timing will be particularly unwelcome for those companies with accounting periods ending on 31 March. The increasing size of pension liabilities is also highlighted by the fact that the funding levels were at 83 percent a couple of years ago, the monetary value of the deficit would have been £108bn – now an 83 percent funding level equates to a deficit of £127bn, almost a 20 percent increase.
“Although our figures monitor the deficit on the basis used for reporting pension deficits in company accounts, the picture will be similar on the funding bases which are typically agreed between trustees and employers for setting deficit contributions to the pension scheme,” added Mr. Tayyebi. Le Roy van Zyl, Principal in Mercer’s Financial Strategy Group, said, “The deterioration in funding positions during March emphasises the significant volatility in the market, and there is little indication that this volatility will diminish any time soon. This set-back is particularly important for a number of schemes and sponsors where 31 March is a key measurement date. Reducing the volatility through a range of de-risking actions has become a primary objective for schemes and sponsors. Particular care is needed to choose and plan for the exact sequence and timing of the steps taken, with a combination of different approaches frequently leading to more efficient and meaningful results. Such a “business plan” has become a necessity. The volatility also means that detailed preparation is required to ensure that implementation can occur quickly once specific market conditions are reached, otherwise it is easy to miss opportunities.”
Mercer’s data relates to about 50 percent of all UK pension scheme liabilities and analyses pension deficits calculated using the approach companies have to adopt for their corporate accounts. The data underlying the survey is refreshed as companies report their year-end accounts. Other measures are also relevant for trustees and employers considering their risk exposure. But data published by the Pensions Regulator and elsewhere tells a similar story.
Today, two disparate worlds
The savings landscape is characterised by a fundamental schism. Saving within a pensions framework provides tax relief on the way in (“EET”), whereas subscriptions to New ISAs (“ISAs”) are made with post-tax income, but withdrawals are tax-free. Consequently, ISAs are “TEE”. Over the last six years, stocks and shares ISA subscriptions have increased by 90 percent, to £18.4 billion in 2013-14, taking the total market value to £241 billion. In the same year, an additional £38.8 billion was subscribed to 10.5 million cash ISA accounts, taking the ISA cash mountain to £228 billion. Clearly, engagement with ISAs is high, confirmed by industry surveys, and acknowledged by the Chancellor when he raised the annual subscription limit by 30 percent, to £15,000, in the 2014 Budget. Importantly, the ISA brand is still reasonably trusted.
Conversely, over the same period, the amount contributed to the EET world of private pensions reduced by 25 percent, to £7.7 billion in 2013-14, a figure which includes basic rate tax relief. Official data excludes SIPPs and SSASs, which attracted perhaps another £6 billion. It is clear from the manner in which basic rate taxpayers are saving (i.e. 84 percent of all taxpayers) that the lure of 20 percent tax relief on pension contributions is insufficient to overcome pension products’ complexity, cost and inflexibility (until the age of 55), as well as a widespread distrust of the industry. In addition pension products are increasingly at odds with how people are living their lives, particularly Generation Y (broadly, those born between 1980 and 2000). Ready access to savings is the key requirement, valued above tax relief. Indeed, Generation Y is so disengaged from private pensions that the industry’s next cohort of customers could be very thin. Consequently, they are missing out on upfront tax relief: an EET tax framework for retirement saving is failing the next generation.
The 2014 Budget
Following the 2014 Budget, there is now no obligation to annuitise a pension pot. This shatters the historic unwritten contract between the Treasury and retirees, that the latter, having received tax relief on their contributions, would subsequently secure a retirement income through annuitisation. This expectation was made clear by Lord Turner’s Pensions Commission, which explicitly linked the receipt of tax relief with annuitisation, thereby reducing the risk of becoming a burden on the state in later life. “Since the whole objective of either compelling or encouraging people to save, and of providing tax relief as an incentive, is to ensure people make adequate provision, it is reasonable to require that pensions savings is turned into regular pension income at some time.”
In addition, a subsequent review of annuities by the Treasury stated thatthe fundamental reason for giving tax relief is to provide a pension income. Therefore when an individual comes to take their pension benefits they can take up to 25 percent of the pension fund as a tax-free lump sum; the remainder must be converted into a pension – or in other words annuitised.
It is patently clear that tax relief and the 2014 Budget’s liberalisation are incompatible: the door is wide open for wholesale reform, not tinkering, of tax relief. This has been recognised by the Treasury Select Committee which, in its response to the 2014 Budget, commented that in light of pensions’ improved flexibility, ISAs and pensions will become increasingly interchangeable in their effect. It went on to suggest that the government should work towards a single tax regime to reflect this, and also examine the appropriateness of the present arrangements for the pension 25 percent tax free lump sum.
The committee chairman, Andrew Tyrie MP, was clear: in particular, there may be scope in the long term for bringing the tax treatment of savings and pensions together to create a “single savings” vehicle that can be used – with additions and withdrawals – throughout working life and retirement. This would be a great prize.
Pensions tax relief: expensive
Today’s tax-based incentives for pension saving are hugely expensive, totalling over £52 billion in 2013-14, in the form of:
(i) upfront Income Tax relief on contributions (£27 billion);
(ii) NICs rebates related to employer contributions, facilitated by salary sacrifice schemes. These take advantage of a tax arbitrage at the Treasury’s expense, and cost some £14 billion annually (a figure that will accelerate with auto-enrolment);
(iii) roughly £4 billion on the 25 percent tax-free lump sum; and
(iv) some £7.3 billion in respect of the investment income of both occupational and personal pensions schemes assuming relief at the basic rate of tax. HMRC does not make an estimate of the relief provided for capital gains realised by pension funds.
To put this into perspective, this is over 93 percent of 2013-14’s Total Managed Expenditure the Education (£56 billion), and substantially more than Defence (£43 billion), and about the same as the combined budgets for Business, Innovation and Skills (£33 billion), Transport (£14 billion) and Energy and Climate Change (£8 billion).
Pensions tax relief: inequitable
Income Tax is progressive, so tax relief is inevitably regressive. Consequently, the broad acceptance by society that higher earners pay higher rates of Income Tax is nullified because affluent baby boomers are able to minimise their Income Tax by harvesting tax relief on pensions contributions. And for those within touching distance of the private pension age of 55, shortly thereafter, they can access their pots to withdraw the 25 percent tax-free lump sum and, in many cases, drop down to a lower tax bracket before making further (taxable) drawings. Only one in seven (roughly) of those who receive higher rate tax relief while working go on to ever pay higher rate Income Tax in retirement. In this respect, tax relief is not Income Tax deferred, as claimed by proponents of higher and additional rates of tax relief.
Consider some evidence. In 2012-13, 10.8 million workers received tax relief of £28 billion on their (and employer) contributions, while a similarly sized pensioner population of 11.4 million paid only £11.5 billion in Income Tax. This latter figure will rise as the population ages, but there is no prospect of the Treasury recouping its investment through Income Tax paid by pensioners. Higher and additional rates of tax relief are at a huge net cost to the state: they are a bad investment of taxpayers funds. Recurring budget deficits are one by-product of this financial largesse (which makes a nonsense of the headline 40 percent and 45 percent rates of Income Tax), and the accumulating debt mountain will loom over the next generation. Another consideration concerning fairness is that Treasury-funded tax relief boosts the volume of assets that fund managers have to manage, and therefore their income. Indeed, the Treasury is the fund management industry’s largest client: since 2002, it has injected, through people’s pension pots, over £300 billion of cash, on which charges and fees are levied. This is akin to a state subsidy of one of the highest paid industries in the world.
Pensions tax relief: ineffective
The purpose of a tax relief is to influence behaviour. However, it is evident that for many of the wealthy, tax relief on contributions to pension pots is primarily a personal tax planning tool, rather than an incentive to save: they would save without it. Consequently, it is extraordinary that we accept a framework which provides the top 1 percent of earners, who are in least need of financial incentives to save, with 30 percent of all tax relief, more than double the total paid to half of the working population. This inequitable distribution of tax relief partly explains why the huge annual Treasury spend has failed to meet the policy objective, which is to establish the broad-based retirement savings culture that Britain desperately needs.
In addition, tax-based incentives to save have been found to be largely ineffective because most people (perhaps 85 percent of the population) are passive savers: they do not pro-actively pursue such incentives. Default (“nudging”) policies are deemed to be far more effective for broadening retirement savings across those who are least prepared for retirement, i.e. lower-income workers, in particular. The Danes, for example, concluded that for each DKr1 of government expenditure spent on incentivising retirement saving, only one ore (DKr 0.01) of net new savings was generated across the nation. Given that Denmark is not wildly different to the UK (both culturally and economically), one could conclude that much of the UK Treasury’s spend on upfront tax relief is wasted. So, what to do?
Savings tax unification: inevitable?
Successive saving-related policy initiatives taken by the current government could be interpreted as stepping stones towards the ultimate merger of pensions and ISAs. These include:
(i) several reductions in pensions’ lifetime and annual allowances, from £1,800,000 and £255,000 respectively in 2010-11, to £1,250,000 and £40,000 today (with the lifetime allowance being further cut to £1 million in 2016);
(ii) significant increases in the ISA’s annual limit (up 30 percent to £15,000 in the 2014 Budget) and, with the addition of a Help to Buy ISA (2015 Budget), an expansion of the ISA range;
(iii) the end of pensions’ so-called “death tax” (announced at the Conservative Party conference), followed by its abolition for ISAs (2014 Autumn Statement); and, of course,
(iv) the annuitisation liberalisation announced in the 2014 Budget, effective April 2015.
There was also a hint in the 2014 Autumn Statement that NICs rebates on employer contributions to pensions could be under review, when the Chancellor said that the Treasury would be taking measures to prevent “payments of benefits in lieu of salary”. Ending them would equalise the tax treatment of employer and employee contributions, and finally put an end to salary sacrifice schemes, long overdue.
The Treasury’s perspective: TEE preferred
From a Treasury cashflow perspective, moving the whole savings arena onto a TEE basis would be hugely attractive. The cash outflow would move back in time, by up to a generation, as upfront tax relief, paid out to today’s workers, would be replaced by Income Tax foregone from today’s workers, once they had retired a generation later. In addition, transition would provide the Chancellor with an opportunity to make a significant reduction in the deficit. This could be The Great Trade to do.
Implementation: the Australian experience
Until 1983, the tax treatment of Australian retirement savings was EET, i.e. as per the UK today, with lump sums taxed at 5 percent. The first transition step was to increase tax on lump sums to between 15 percent and 30 percent, depending upon the recipient’s income. Then, five years later, in 1988, Australia introduced a 15 percent tax on contributions and income, and a 15 percent tax rebate on retirement income: essentially a “ttt” arrangement, where the small “t” denotes an effective tax rate below the individual’s marginal rate of Income Tax. This framework endured for nearly 20 years until, in 2007, Australia removed any tax liability on retirement income in respect of contributions that had already been taxed: “ttE”. Lump sums at retirement attract the lower of the retiree’s marginal rate and 16.5 percent, up to a size cap, with the marginal rate on sums above the cap.
Australia’s ttE is not so different to TEE: the burden of taxation in both cases falls at the time of saving, with retirement income being tax-free. Australia has pondered whether to go to tEE, i.e. to remove any tax burden during accumulation, but with almost A$2 trillion of assets sitting in the pension system, the government could not afford to leave it completely untaxed.
Big Bang preferred
Australia’s transition experience to ttE was not ideal; it has left savers and providers having to keep track of pots with three different post-retirement tax treatments, depending upon the timing of the contributions. In the interests of simplicity, the UK should grasp the nettle and adopt a clean “Big Bang” approach, to avoid some form of protracted, progressive, transition. The Treasury should identify a date when EET simply ceases in respect of all future contributions. Existing pension pots would close to further contributions, to be left to whither naturally, with the saver paying his marginal rate of Income Tax on withdrawals.
So, what should replace private and occupational pensions in a purely TEE savings arena?
The Workplace ISA
The Workplace ISA beckons and, for those without an employer sponsor, alternative (competing) providers should be available, including NEST (the NEST ISA). These ISAs could incorporate a form of risk pooling in decumulation (i.e. auto-protection), to spread the post-retirement inflation, investment and longevity risks that few of us are equipped to manage by ourselves. Participation, however, should be optional, enabling savers to embrace the 2014 Budget’s post-retirement liberalisations (notably, to take cash from pension pots).
Workplace ISAs should include one or more features that maintain employer participation in retirement saving provision: today, employers contribute roughly 75 percent of all pension contributions. Any financial incentives, such as NICs rebates on employer contributions (note that TEE refers to the saver’s Income Tax, not employer NICs) should, however, probably be accompanied by some form of “lock-up” period. Certainly, employers should be consulted. Workplace ISAs should be included in the auto-enrolment legislation, and excluded from means testing purposes, as per today’s pension assets.
Finally, we could explore evolving TEE into “Taxed, Exempt,Enhanced”, redeploying some of the savings from having ended upfront tax relief into post-retirement top-ups: particularly appropriate given today’s interest rate environment. The Swiss, for example, subsidise annuities, which perhaps explains why they have the highest level of voluntary annuitisation in the world (some 80 percent of pension pot assets). We could extend the concept to include drawdown. A forthcoming paper will go into more detail.
