This article was originally commissioned and published in June 2015 for Investment Life & Pensions Moneyfacts publication. Tom Murray argues that merging ISAs and DC pensions to create a lifetime savings product would transform the savings landscape and bring some much needed clarity.
Lifetime Savings Product - A crystal clear concept
The word pension has been in general usage for decades, if not centuries and you would therefore assume that the meaning of the word is crystal clear. It is defined in my dictionary as ‘a sum of money paid regularly as a retirement benefit or by way of patronage’. While you may dispute the precise definition, it certainly accurately portrays the way that most people not involved in the financial services sector think about pensions. Thus, when the general public are told that they are saving for their pension, a regular, guaranteed fixed amount is always what they assume is going to be available at the end of it.
Leap of Faith
Recently a colleague met up with a priest in order to arrange her wedding. After finding out she worked in the life and pensions industry during the initial casual chat, the priest insisted on telling her about his most recent meeting with his IFA. When the IFA had shown him the projection of his likely pension fund at retirement age, and how much that could mean as a regular income from an annuity, he asked the IFA to give him something signed which would guarantee the amount. When the IFA pointed out that he couldn’t guarantee the amount and that the projection was only a guess based on best estimates of investment returns etc., the priest was appalled. He couldn’t get his head around the idea that someone would take his money without guaranteeing what he would get in return and felt the whole industry was a ‘bit of a con job’.
The trouble is that this type of reaction is not unusual. The priest, an educated man, could not get away from the idea that he was saving for a pension and that therefore, come his retirement, he should be guaranteed a level of payment that was in some proportion to his current earnings. And that lack of understanding poses a big problem for the whole financial services sector.
Those of us who work in the life and pensions sector are fully aware that there are many types of “pension” products on the market and the advantages and disadvantages of each of them are almost built into our DNA. What we constantly forget is that people who don’t work in the industry only occasionally come into contact with these products, and consequently have a far more simplified idea of what the word pension means.
A lot of this confusion is engendered by the industry itself. Whilst the differences between defined contribution and defined benefit are clear to those who constantly deal with these terms, to others they are all the same. The very fact that a defined contribution plan, essentially a regulated, tax-favourable plan, is called a pension is mystifying. Yet we continue to call it that despite the fact that it is clearly misleading to the average punter.
This was less so when it was compulsory to take an annuity or a GAD regulated drawdown product from the final amount saved. Then the result of the saving could still be seen in terms of a regular amount that the individual would receive from retirement to death, in essence a reduced salary. The new pension freedoms break this link and now the result is that people will receive a lump sum which they are not actually knowledgeable enough to work out how to transform this into some type of regular, dependable income stream that they are expecting after a lifetimes saving.
While the reality is that most private sector workers no longer have defined benefit pensions, many in the public sector still do. The idea of a good job being ‘permanent and pensionable’ has been around for so long that it is not surprising that it is ingrained in the consciousness of the public. This strengthens the link in people’s minds between pension saving and some kind of regular income stream that mimics earnings, and will be there forever (or at least until they die which for most people is the same thing).
When they find out that this isn’t true, it confirms to them the idea that the financial services industry is not to be trusted. My colleague’s priest is not the only one who believes that giving money to someone who can’t guarantee what will be given back in return is a bit dodgy, particularly when the money is actually one’s life’s savings. The idea that by the time one finds out what the tangible return is, it is too late to do anything about it would be deemed laughable, if not downright corrupt, in other industries.
Confidence in the financial services sector was already low due to the banking crisis when the earthquake of pension reform was unleashed this April. The move took everyone by surprise when it was first announced in the March 2014 budget, as it appeared to run contrary to the bi-partisan strategic goal set over the previous decades that the number of people provisioning for their own retirement had to be increased, or the burden on future taxpayers would become unbearable. As part of this pact, the government, representing the taxpayer, would contribute to the savings of all those who were auto-enrolled into the system.
The justification for taxpayer support of pension saving now appears spurious. Given the fact that it is possible for the individual to splurge their pension pot immediately upon reaching their retirement age, the savings they have accumulated over a working lifetime may play little or no role in reducing the pressure on the government in terms of pension provision and therefore the taxpayer is now paying out with no guaranteed return. This situation is inherently wrong and is unlikely to endure long.
Is ‘a’ ISA better?
In the meantime, there is the ever-increasing popularity of Individual Savings Accounts (ISAs). These do not give a tax break on contribution but the growth and the withdrawals are tax-free, inverting the position of the pension. In fact the point has now been reached where far more people are saving in ISAs than are saving in pensions, auto-enrolment notwithstanding, over 13 million had an ISA in 2014 compared to a little over 6 million who had a personal pension. Granted there are many who had a workplace pension scheme but in 2013 only 46% were actually contributing to the scheme. It appears that ISAs are more attractive to individuals to save as they find them easier to understand, and can access them when they need to.
The time has come to review whether we should be returning to the original idea of pensions, in terms of terminology. The ‘P’ word should only be used to refer to pensions that are guaranteed for life, either defined benefit pensions or pensions that are in payment from an annuity. Defined contribution plans are essentially tax-efficient long-term investment plans or tax efficient long-term savings plans, depending upon the risk level selected and it would be far clearer to the public if they were referred to as such.
At least this way, people would be sure about what they were buying and the disparity between their ‘pensions’ and those of the public sector would be a lot clearer – which it should be, given that all taxpayers are paying for the public sector pensions.
Two paths - one destination
In essence, we now have two long-term, taxpayer-encouraged, savings and investment plans (ISAs and DC pensions) and the question arises as to whether we should now be thinking of simplifying the situation by looking to merge them?
However there is one problem – they are tax incentivised in different ways. The DC pension savings are tax free at point of contribution and investment growth but are taxed when you draw from them. ISAs are taxed at contribution but untaxed at growth and drawing. This is an inconsistency that could be rectified in either way but it would surely be a far better for the average saver if their tax approaches standardised. This would make it easier to merge the two products and allow the user far more control over when they can access them.
We need to get lower earners saving. For this purpose, it was previously thought that the immediate addition of the tax-relief in the case of DC pensions was crucial but it is clear that this has not been the case. The immense popularity of ISAs has shown that the public can easily understand the value of their tax-free benefit. Far more people have an ISA than has a pension and they didn’t have to be nudged into it via auto-enrolment.
There would appear to be no reason not to move to the ISA approach for the merged savings and investment instruments. This would have the beneficial effect in the short term of helping the government to get their finances under control, as it would remove the cost of providing the immediate tax-relief on the pensions. This would also simplify the burden of taxing pensioners in the future, as those living only on their savings and state pensions would in effect be able to live tax-free, saving elderly people the hassle of trying to make their annual returns from multiple pension schemes they may have built up over their lifetime.
Savings are for life, not just for Christmas
Once we have simplified the whole savings and investment landscape in this way, we would be better positioned to look at further changes to encourage saving and investment among lower and middle earners. This would be very useful as there have been some key areas that haven’t been addressed by the government, and it would be better to address them against a simpler background rather than against a more complex one. The idea of a lifetime savings product, which would allow drawdown for key events, would be superb and would transform the savings landscape. The type of events would include self-education, initial house purchase, marriage, education of children, retirement and finally, long-term care. It is easy to see how the merged ISA/Pension could be given something of the flavour of the Kiwi-saver plans in New Zealand which would ensure that the majority of the population are not only au fait with but actually are saving for their main life events.
If from an early stage, whilst in school for example, the concept was brought home to people of the need to utilise this account in order to provide for these key milestone events, there would be a far better preparedness among the population for them, and consequently far more saved. The idea of compulsory saving is not acceptable to most people but nudging the workforce into saving in their lifetime account à la auto-enrolment is an idea that should be easy to sell.
Whether or not one agrees with Margaret Thatcher’s original view, what is certain as the population ages is that the UK can no longer afford “the State to appear in the guise of an extravagant God fairy at every christening, a loquacious companion at every stage of life's journey, the unknown mourner at every funereal”. The most the state can do is to help people to prepare for these events by educating them about the need for long-term saving and incentivising them to do so. Simplifying the regulated savings landscape by merging ISAs and DC Pensions would be a good way to start.
What do you think? Let us know in the comments below!