Monday, 30 March 2009

Reform of tax relief on pensions should be accompanied by pension reform

Jim Stewart: The solution to the current pensions crisis proposed by TASC in its pamphlet Making Pensions Work for People is to introduce an improved basic state pension, and an earnings related top-up scheme. The proposal is that this would be paid for by reducing existing tax reliefs.

Some have suggested that, in the current economic crisis, tax reliefs on pension provision should be given at the standard rate as a means of reducing the government borrowing requirement and maintaining existing expenditures, without any pension reform.

Tax reliefs on pensions need to be reformed for a number of reasons, including their cost:-

(1) Pension related tax reliefs cost €2.9 billion (2006 figures) in terms of tax foregone;
(2) They are of greatest benefit to those with the highest incomes because those with the highest incomes contribute proportionately more than lower income groups and have greater tax relief because of higher marginal tax rates.
(3) Because of tax reliefs and the extensive exemptions from annuitisation, pension provision can be regarded as one of the most tax-favoured means of saving, rather than of pension provision, for example as in the recent case involving the Irish Nationwide. Some of this advantage was, however, lost through investment in high risk assets. In December 2007, the equity allocation of Irish pension funds amounted to 65% overall (and 77% for those pension funds with no investment mandate from trustees).

In addition, pension funds are subject to annual average charges of 1.5% per annum (Green Paper, p. 142). This means that annual charges amount to a substantial proportion of the cost of tax reliefs (50% in 2003).

As a result, due to charges (which are largely independent of investment performance) and losses on investments, many of those contributing to a defined contribution (DC) type scheme over a ten year period, even with tax relief (at 41%), may have been better off investing their pension contribution in a deposit account which does not attract tax relief*. Those who paid tax at the standard rate and who invested in a deposit account savings scheme over the past ten years would be substantially better off.

Giving tax relief at the standard rate rather than the marginal rate would reduce tax induced income inequalities and, in so far as pension provision is in reality a form of savings, reduce distortions in the savings market.

The Irish Nationwide/Fingleton case has drawn attention to exemptions from tax on lump sums paid on retirement. Tax free lump sums should be reduced substantially or removed entirely on private sector pension payments. Lump sums paid in the public sector as part of pension provision should be subject to tax.

There is a crisis in private sector pension provision. Many of those nearing retirement, or in retirement, have suffered large reductions in wealth and income. As a result many are or will become far more dependent on the basic state pension than they planned for. The current basic state pension, at approximately 30% of the average industrial wage, is insufficient to ensure a reasonable level of income replacement on retirement. There are several reasons why tax reliefs for pension provision need reform, but it would be a mistake to reform tax reliefs for pension provision without also reforming pension provision in terms of equity and long-term sustainability. Detailed proposals have been developed by TASC and published in the pamphlet Making Pensions Work for People.

Using the following assumptions: negative returns of 2.8% per annum for pension fund returns over the past ten years (see here), average costs of 1.5% per annum, marginal tax rate equal to 41% over the 10 year period and return on a deposit account of 6.5% (5.2% after DIRT of 20%), a pension fund investment has a slightly higher return than a deposit account over a 10 year period.

Dr. Jim Stewart is a member of the TCD Pension Policy Research Group, which has collaborated with TASC on its pension reform proposals


Pavement Trauma said...

What happens when pension tax relief is only given at the standard rate?

In the case of defined contributions, it is pretty clear - employees will only get 20% back of their contribution and will pay tax 21% (41-21) of any employer contribution.

In the case of defined benefit scheme members, employee contributions (to say buy back years service) will only get 20% back of their contribution. But how will employer contributions be treated? On the value of monies they put into the fund? If so, how are these broken out per employee? On the 'actuarial value' of the pension to the employee - but under what assumptions?

Jim Stewart said...

Allowing deductions for pensions at the standard rate for an employee, does not change the tax position of employer contributions in the case of contributions to DB or DC schemes, because employer contributions are not taxed, as they are not regarded as benefit in kind. In addition employee contributions to an approved pension scheme receive PRSI relief.

Employer contributions can as before be offset against corporation tax.

Some schemes allow trhe purchase of aditional added years at full actuarial value, for example in the case of teachers, and these contributions can be offset against income tax.

The Green Paper on pensions (Table 7.2, p.106) includes a notional estimate of the BIK cost in terms of reduced tax revenue of employer contributions to pension schemes.

Allowing pension deductions at the marginal rate creates anomalies and inequity. These features would become even more exaggerated if a new higher rate of income tax were introduced

Pat Donnelly said...

Pensions are revealed as a dubious scheme. And now we need to reform the system. Just remember that growth is not guaranteed and that asset deflation is likely for some time. And that the economy will be contracting for some time. So a holiday from compulsion should be allowed?
And excess should be curbed as the legitimate expectation of the citizen is that it won't be used as a tax shelter for those who have the odd 26Million handy. How about a maximum of 5 times the minimum wage attracting tax relief at a notional 40 hrs a week? Hee hee! Say yes!

Pavement Trauma said...

Thanks for the clarification about the employer contributions.

It seems quite strange to me that employee and employer contributions would be treated so differently when the end result is the same. It would be rather easy (particularly for the 'upper echelons') to game the result - for example by redirecting bonuses and pay rises to be employer pension contributions instead (assuming 'pay rises' and 'bonuses' ever make a come back).

Surely it would be much more equitable to make employer pension contributions BIK taxable?