Beware these bad ideas about reforming the taxation of pensions

Almost every government has tinkered with pensions, an area of financial life that needs stable structures and a long-term perspective. For 30 years this has not caused much concern nor done much apparent harm. But recent changes, and promises of more to come, should be sounding a louder warning than they have.

The area where most damage is being done is the tax treatment of private-sector pensions, which are now overwhelmingly defined contribution rather than linked to final salary. Until nine years ago all money paid into these schemes, by individuals and by employers, was tax-free. Then a cap was introduced, so payments were tax-free only into pots of less than £1.5m. From next April the cap will be cut to £1m, which would buy an annuity for a couple of only £27,000 a year. The election campaign suggests more is to come: the Tories say they will reduce tax relief on pension contributions from higher-rate tax payers to pay for a cut in inheritance tax, and Labour promises something similar to pay for reducing university tuition fees.

The reason for all these changes lies in the cost of tax exemptions for pension savings: a total of £52bn in 2013-14. A big figure by any standards, and it comes from individual contributions to schemes from untaxed income (£27bn), rebates on employers’ national insurance for what they put into schemes (£14bn), £7bn because pension schemes don’t pay tax on their investment income, and finally the cost of allowing people who reach retirement age to withdraw 25 per cent from their pension pot tax-free (£4bn). At a time when chancellors and would-be chancellors are desperate for money, these billions become irresistible.

Such a tangle of figures and rules cries out for a mind-clearing paper from a think-tank. Sure enough, along comes a report – but one that only confuses things even more, alas. The Centre for Policy Studies (CPS) proposes ending tax breaks on contributions to pensions, and introducing them instead on what the schemes eventually pay out. In the pamphlet’s lexicon, today’s EET – Exempt (on contribution), Exempt (while invested), Taxed (when withdrawn) – should be replaced by TEE. In this brave new world, people would save out of taxed income, their pension pot returns would be exempt and then they themselves would receive a tax-exempt pension.

The CPS sees Isas as genuine alternatives to pensions. They aren’t. Take out an Isa and you can always decide to cash it in next year. Start a pension plan and you know this is a 30 to 40-year disciplined commitment.

Any change from EET would therefore be a bad mistake. It’s hard enough for young people to start saving for retirement, but at least EET gives them a chance to get going with money that hasn’t been taxed. More important, who would believe the last part of TEE – that when they do eventually get access to their pot, their income really would be tax-free? The evidence from EET shows how politicians love fiddling with pension schemes; with TEE they wouldn’t suddenly stop. The fear of that would, on its own, discourage long-term saving.

A useful think-tank report would have highlighted two issues to unite the parties around a better way of thinking about pensions. First: the economy. All parties seem to agree the recovery of 2012-15 has been dangerously unbalanced, depending too much on consumer spending, while net exports and investment have languished. If people consumed less and saved more, it would help correct this imbalance and also reduce Britain’s trade deficit. And it would start to shrink household debt, which is still close to its all-time high as a percentage of GDP, and dangerously vulnerable to higher interest rates.

The second area of consensus is that people should be saving more for their retirement, hence the introduction of auto-enrolment schemes, which any conceivable future government will want to drive further. But even a big increase in auto-enrolment contributions, coupled with the new single state pension, will not ensure a decent income in retirement for all. Most pension consultants reckon people should aim for a pension that is at least 50 per cent of their annual working income.

Today’s pensioners, many of them the much-blessed baby-boomers, are doing fine, but a lot have final-salary pensions as well as numerous untaxed perks from the government. The perks simply aren’t sustainable, and at some stage a government will cut them back.

That is for the future. Right now, it’s worth emphasising that all parties agree on the benefits of more personal saving; but how best to achieve it? In 1974, one of Britain’s Nobel Prize-winners for economics, Professor Sir James Meade, chaired a commission for the Institute for Fiscal Studies and concluded that all saving should be exempt from tax. Even if nirvana was out of reach, the commission said, governments should move in that direction. By hacking at the pension system, politicians are going the other way. It will be bad for individuals – and for the whole economy.

Rupert Pennant-Rea is the chairman of the mutual insurer Royal London chairman of Royal London