When the Coalition Government came to power in 2010, their two main aims were closing the deficit and restoring Britain to economic growth. However, following the 2014 Budget speech, it appears that changes to pensions will be their biggest legacy. David Kingman explains
Major changes to the rules surrounding private pension saving were the biggest announcement in Chancellor George Osborne’s 2014 Budget speech. Arguably, these reforms were targeted at older voters who are feeling anxious about their pensions as they approach retirement. But what impact will the Coalition’s reforms have on young people, who are just starting to put money aside now?
The end of annuities?
The reforms to private pension saving which were announced during the 2014 Budget speech are fairly straightforward to explain. They address how savers are allowed to use the money they have saved up in their pension pot when they want to begin turning it into an income which they can live on during retirement.
Under the previous system, they essentially had two options. What most people did was to purchase an annuity from an insurance company – a financial product which would guarantee to pay them an income every year for the rest of their life. How much they would get depended on how much money they had in their fund, as well as other factors such as their age, life expectancy and state of health.
The other option was to take what is known as “income drawdown”. This means that the saver can withdraw a certain percentage of their fund’s value as an income each year, while the rest of it remains invested in the stock market. Unless the pensioner has an income worth at least £20,000 per year from other sources, the amount which they can withdraw has previously been capped, with any withdrawals above this attracting a 55% tax rate.
Both of these options have become increasingly unpopular over recent years. Although annuities are still taken out by around 400,000 people annually, they have been criticised for offering poor value for money, as the typical annuity product will currently only provide an income which is worth around 5% of the fund’s value (so a fund worth £100,000 would provide an annual income worth just £5,000 per year).
The decision to purchase an annuity is a one-way street, with no opportunity to change annuities if the pensioners in question find they could get a better deal somewhere else; and if they die, then the money is no longer part of their estate. It’s possible to spend your life savings for an annuity only to pass away within a couple of years and lose virtually all of the money.
The problem with income drawdown has been that it involves too much risk for many pensioners, as the value of the fund can still go down during retirement. Although slightly better than for annuities, the returns have also been disappointing. The precise method used for calculating how much income a pensioner can draw down each year is complicated, but the current maximum amount that a 65 year-old with a fund worth £100,000 could withdraw before they hit the 55% tax rate is about 7% – giving them an income of £7,000 per year.
The long-term impact of the Chancellor’s reforms will be to give people entering retirement a great deal more freedom. After 2015, savers will be allowed access to the whole of their pension pot from the age of 57 at their marginal tax rate (and the first 25% will still be available tax-free, as is currently the case).
Suddenly, pensioners who have a fund worth £100,000 will be allowed to withdraw the whole lot in one go (although they would have to pay higher-rate tax on £75,000 of it); or they could draw down smaller amounts over several years to reduce their tax bill. At that point, they will be free to spend or invest it however they want to.
Of course, purchasing an annuity will still be one option which is open to them, but the drawbacks associated with going down this path mean that many fewer people are likely to choose it. Some commentators have even suggested that this change could spell the death of the annuity market, and several of the top annuity-providers saw their share prices drop by a combined total of £5 billion on the day of the Chancellor’s announcement.
Bad for young taxpayers?
Commentators have been quick to point out the degree of moral hazard which younger taxpayers are being signed up for under the new arrangements. The Government has argued that people should have freedom to spend their savings as they see fit – “it is their money”, as the Chancellor has argued in response to criticism of the changes. However, there is a danger that pensioners could exhaust their savings before they reach the end of their lives, either because they decide to blow them on cars and holidays (hence pension minister Steve Webb’s controversial “Lamborghini” comment), or simply because they live longer than they thought they would. This could leave them relying on state benefits for support, creating a bigger bill for future taxpayers.
Young people could also be affected negatively in other ways. For example, given that property currently offers some of the best investment returns available, there are fears that giving people the freedom to withdraw all their money early could spark a fresh buy-to-let boom which would make it even harder for young people to get on the property ladder.
There are two interesting sub-plots in this debate. Firstly, a move towards greater use of means-testing within the welfare state looks inevitable as the population ages – indeed, the Government is on the verge of introducing a new system of means-testing for old age social care. This could give pensioners a strong financial incentive to run through their assets as quickly as possible, making the moral hazard for taxpayers even more pronounced.
Secondly, the Government is actually predicting that the financial impact of these reforms over the next five years will be higher tax receipts for the Government – possibly to the tune of over £1.2 billion – as pensioners pay more income tax and spend more. In other words, the Government appears to be banking on this causing a short-term fiscal stimulus, but this seems likely to lead to a lower overall tax-take later on. So there is a strong danger that this move could pass a greater burden on to future taxpayers, in return for helping the current generation of older savers to enjoy themselves.
…But good for young savers?
However, it should also be remembered that many of today’s young people are saving for pensions themselves. Indeed, when looked at in combination with one of the Coalition’s other flagship pension policies – auto enrolment – it could be argued that the pensions landscape is now significantly more favourable for young people than it was when the Coalition entered office.
Thanks to auto enrolment – which the think tank Policy Exchange has argued should be made compulsory instead of voluntary, with higher minimum contribution rates as well – most of the current younger generation who work in the private sector will have a fairly large pension pot when they reach their 50s and 60s. Until now, the incentive to save has been diminished by the bleak outlook for what they could do with their savings when they got there, but now that they won’t effectively be forced to buy an annuity, they should be able to look forward to a comfortable old age if they do the right thing and save.
The challenge for the Government will be explaining all this to young people in language that they understand – but if they do that, solving Britain’s “pension crisis” might be their ultimate legacy.