Savings: how to fix a broken system

The Government has called for us all to make suggestions on reform of tax and benefits. It could do much worse than listen to the proposals from the Centre for Policy Studies on simplification of the pensions and savings regime.

The CPS's Michael Johnson  is proposing radical simplification of both pensions and ISAs and a merger of the two.

One of the major objections to pension saving is that money put into a pension scheme is locked away until retirement and is inaccessible. There are many reasons why savings might legitimately be needed before retirement - including redundancy, homelessness and disablement - and the rigidity of the current pensions legislation is a serious obstacle to encouraging long term saving.

The CPS report, outlined on this website yesterday, recognises that individuals want greater freedom to control their own savings and that simplicity is the key.

Main proposals
The main proposals include a flat annual limit of £45,000 a year for all tax incentivised savings with a maximum of £35,000 a year for pensions. Importantly, the CPS would retain tax relief at the savers marginal rate, ensuring that those who pay tax at the top rate of 50% derive full benefit from their pension contributions. This would probably satisfy the many critics of the current proposals to limit tax relief on contributions for higher earners, due to be implemented in April 2011.

But perhaps the biggest reform is the suggestion that there should be ‘fluidity’ between pension and ISA savings through a combination of some pre-retirement access to pension savings and, at retirement, retrospective tax relief on ISA assets being re-nominated as pension savings. The report proposes a combined workplace savings plan incorporating both an ISA and a pension to facilitate this.

Other proposals include allowing partners to fund each other's pension pots and receive tax relief, irrespective of their own earning circumstances as well as permitting savers to bequeath unused pension savings to third parties' pension savings, free of inheritance tax.

‘This should encourage a wealth cascade down the generations and reinforce the sense of personal ownership of pension savings,’ says the report. This might not be so popular with the tax authorities and the Lib Dem element of the coalition as it is a clear benefit to wealthier individuals which lower income families may never enjoy.

Auto enrolment
The CPS wants to see auto-enrolment to include ISAs. This is a good idea as ISAs are a much more suitable investment vehicle for lower income families because of their greater flexibility and the ability to access funds in an emergency, both before and after retirement. It would make them even more attractive if, at retirement, there was an element of retrospective tax relief on contributions. In addition, annuities purchased with ISA-derived funds should be exempt from income tax, says the CPS report, consistent with the tax-exempt status of withdrawals from ISAs.

But perhaps the biggest incentive for change comes through the savings that can be made by reform of pensions which will appeal to the Treasury. It is an unacceptable inequity that wealthier families enjoy billions of pounds in tax savings through relief on massive contributions – up to £245,000 in 2010-11 – which is paid for by lower income families who do not have sufficient disposable income to save, paying a higher basic rate of tax than would otherwise be necessary. This is an unacceptable transfer of wealth from the relatively poor to the relatively rich.

And the CPS paper set out four alternative tax relief structures which could save the Treasury up to £8.5 billion per year, without risking a sharp reduction in long-term saving. As the author desribes it, ‘a rare example of a policy ‘win-win’.

Single framework
It also suggests sweeping away the two-track pension/ISA tax relief regime and replacing it with a single, unified tax framework, one that is easy to understand and attractive to long-term savers. ‘Such a radical simplification is a prerequisite to encouraging more people to save more, and it would, for example, enable the industry to offer customers a simple savings continuum, perhaps under a ‘lifetime savings’ banner,’ says the report.