Sunday 29 June 2008

Tax relief for pension contributions

One loony right wing view (to which I subscribe) is that this sort of social engineering is madness, the best thing we could do is scrap tax & National Insurance relief for pensions contributions (total cost £38 billion, as against total cost of Basic State Pension of £47 bn, to get some perspective) and instead cut more damaging taxes (VAT, Employer's NI etc). For clarity - there would be no tax on money you withdraw from the capital element of your pension fund - in the same way as you do not pay tax when you withdraw money from a bank account.

The other loony right wing view is that people should not pay any tax at all on money put into a savings account, which, to achieve revenues of £X bn would mean higher rates on other income and would of necessity be regressive. These people have never described how it would work on an administrative level (if paying off a mortgage counts as 'saving', would taking out a mortgage be taxed in full as 'spending'? Or would taking money out of your savings account to pay off your mortgage could as 'spending', in which case, taking out a mortgage must count as 'saving'. And it that counts as 'saving', how do you distinguish between taking out a mortgage and running up credit card or other debts, which is clearly 'spending'?) and is a complete non-starter.

A sensible compromise would be to ditch principles, and look at a few facts and figures in deciding what the limit for tax relievable annual contributions should be:

Total market cap of FTSE All Share index, about £1,800 bn (as at last August).
Total number of employees/self employed 30 million.
Total UK government & local authority bonds in issue = £600 billion.
Total number of pensions (who have worked during their lives) = 10 million.

Let's assume that all employees/self-employed are saving the same amount over a forty-year working life. The average amount held in any pension pot would be £60,000 (£1,800 bn divided by 30 million savers), so we'd all start with nothing and end up with £120,000 on retirement. As the combined capital growth plus dividends is roughly equal to annual earnings growth, we can ignore that for simplicity. £120,000 divided by forty years = £3,000 per year. This is a good guide to the amount on which people can get tax relief each year.

At retirement, every saver takes his £120,000 pot and buys bonds (OK, you buy an annuity and the annuity company buys bonds, same thing really). So ten million pensioners would each own an average value of £60,000 in bonds (£120,000 on retirement, £0 on death). Ten million pensioners times £60,000 = £600 bn, in other words, annuity companies would own all UK government and local authority bonds in issue.

At current annuity rates, £120,000 is enough to buy an annuity of £5,473 for a 60-year old man or £3,956 for a 60-year old woman. That's an average of £90 a week.

So this idea that we can somehow all have handsome private pensions in retirement is complete nonsense, there just aren't enough shares and government bonds to go round! A tax system that gives tax relief for contributions of up to £215,000 per year is just completely mad.

A lifetime limit of £1.8 million means that the richest one million or so people would be end up owning all quoted shares and all government bonds, and there'd be nothing left for anybody else to invest in. Madness.

6 comments:

Anonymous said...

ME: "A sensible compromise would be to ditch principles,"

If this one, why not the rest of your 'looney right wing' principles too. Soon you will be able to join the Tory party.

I always thought tax relief on pension contributions was one of 'natural justice' allied with simplicity.

The government is going to tax pensioners when they draw their pension, it would be grossly unjust, to tax them when they draw their pension and when the are building up their pension fund? That would effectively amount to double taxation, no?

If you are trying to encourage people to save for retirement, double taxation would be a sure fire way to frustrate that aim.

Simon Fawthrop said...

Mark,

I was going to make a similar comment to Anon - pensions are deferred income and taxed as such.

In your initial calculation you need to nett off taxes collected on pension payments.

Anon,

We do have double taxation - I spend a lot of time trying to make my savings tax effecient to avoid that problem.

Mark Wadsworth said...

Anon, it's not double taxation! I abhor double-taxation as much as the next man.

Under current system, you pay no tax on what goes into the pot but you pay tax on everything you take out (ignoring the tax-free lump sum), whether that's capital or accumulated income (the interest element of which has been rolled up tax free).

If there were no tax relief and you build up a large fund, then you can withdraw as much of the capital as you like without paying tax again (like when you take money out of your bank account). The interest element would be taxed either way (I see no reason to tax dividends or capital gains).

And simple it isn't!

That wasn't the point of this post anyway. The question is, what is a sensible annual limit for tax-relievable contributions: £3,000? £10,000? It sure as heck ain't £215,000!!

GS, good point on taxes collected on pensions in payment; that gets the cost down by a bit less than half, call it £25 bn net or something.

Anonymous said...

So this idea that we can somehow all have handsome private pensions in retirement is complete nonsense,

Does this argument also apply to DB pensions? Just the private ones? Or public sector ones as well?

there just aren't enough shares and government bonds to go round!

Perhaps, if we limit our investments to UK shares and bonds. What about including foreign markets?

At current annuity rates, £120,000 is enough to buy an annuity of £5,473 for a 60-year old man or £3,956 for a 60-year old woman. That's an average of £90 a week.

I'm hoping my private sector DB pension will (assuming I get enough years of contributions) pay out a LOT more than this.

Mark Wadsworth said...

Ed Does this argument also apply to DB pensions? Just the private ones? Or public sector ones as well?

Private = shorthand for stuff where the underlying investments are shares and bonds (be that DB, DC, final salary, SSAS, SIPP etc). Public sector pensions are paid out of current taxation.

Perhaps, if we limit our investments to UK shares and bonds. What about including foreign markets?

Sure, but if you include foreign stuff what are their pensioners going to live off?

I'm hoping my private sector DB pension will (assuming I get enough years of contributions) pay out a LOT more than this.

Fine, but it is a zero sum game.

Anonymous said...

Private = shorthand for stuff where the underlying investments are shares and bonds (be that DB, DC, final salary, SSAS, SIPP etc).

I guessed you were talking about private DB as well - just wanted to confirm.

Public sector pensions are paid out of current taxation.

That is one of the problems with them. Of all people, public sector workers should not be allowed to have DB pensions, even if the scheme is fully funded. Having a DC pension instead would force each individual worker to balance their support for higher government spending vs the private sector investment performance they will be relying upon to fund their retirement.

Sure, but if you include foreign stuff what are their pensioners going to live off?

Is that our problem?

Fine, but it is a zero sum game.

Rather a depressing message. Can the pot not grow big enough, fast enough to afford better pensions for all? Maybe not - perhaps the number of pensioners we will have in the future, and the average time they live in retirement is just too large. So we are back to the age old conflict between freedom and equality.