Savers fear budget raid on pension nest eggs

Pension providers and savers are concerned that the forthcoming budget could reduce tax relief on contributions, writes CAROLINE MADDEN

THE PRE-EMERGENCY budget rumour mill has whirred into action and one of the main predictions now doing the rounds is that the Government’s cross hairs are squarely trained on pensions or, to be precise, pension tax relief.

One rumour is that relief at the higher rate of income tax on pension contributions is to be scrapped, and that relief will only be available at the standard rate.

Another theory has it that pension lump sums taken at retirement will become taxable. Whether these predictions are accurate is debatable – the Department of Finance as usual refused to comment on any aspect of the upcoming budget.

It should be borne in mind, however, that the pensions industry benefited from similar rumours in the lead-up to the early budget last October. Providers were overrun with people making extra pension contributions in advance of the budget, fearful that unfavourable changes would be announced. The rumours were branded as scare-mongering at the time, and the more cynical observer might wonder whether or not there is an element of this at play now.

Either way, the last thing the pensions industry actually wants is for these rumours to become a reality. Anything that discourages people from contributing to private retirement funds is bad news for pension providers.

Regardless of their motivations, members of the industry have made a convincing argument against cutting pension tax relief. First of all, according to the Irish Association of Pension Funds (IAPF), axing this relief would not release € 3 billion into the Exchequer funds as is commonly argued. The maximum the Government could hope to raise by adjusting the pension tax relief system is about € 300 million, the IAPF said in a briefing paper on the issue.

True, in its Green Paper on pensions, the Government estimated that the cost of providing tax relief for private pensions in 2006 was €3 billion, but the IAPF has dismissed this figure as being out of date and based on invalid assumptions.

For example, the Government estimated that the biggest element of cost is the tax forgone by allowing investment income and gains to roll up tax-free in a pension, which is estimated to have cost € 1.2 billion in 2006. “It is clear that it would be impossible for the State to turn this amount into revenue at the present time given the depressed returns on global investment markets,” the IAPF countered.

Also, tax relief on pensions is effectively deferred tax, as (apart from a tax-free lump sum) the individual is taxed on their pension when they draw it down. But the figure of € 3 billion fails to take into account the deferred tax falling due when the underlying pensions are paid. “This would give a substantially lower figure,” the IAPF said.

And perhaps most importantly from an individuals perspective, reducing or abolishing tax relief on pension contributions would remove the only remaining incentive for people to provide for their retirement through a pension. Pension savers are already wondering whether it’s worth continuing to contribute to retirement funds that have fallen by more than 30 per cent on average in the last year alone. By disincentivising individual pension provision, the Government is simply storing up problems for the future.

“Restricting the tax relief to the standard rate would lead to a reduction in the amount individuals contribute to their retirement funding at a time when people should be increasing their contributions. This may be good short-term news for Revenue but it has many knock-on effects such as [an] increase in the ‘savings gap’,” said Mike Kemp, chief executive of the Irish Insurance Federation (IIF).

In 2007, the IIF estimated that a retirement savings gap of € 7.4 billion existed in the Irish labour force. “With the massive falls in asset values since then, these figures have undoubtedly deteriorated further,” the IIF said.

“We estimate that 30 per cent of individual pension holders would suspend all contributions, including the majority who make a lump-sum contribution at the end of the tax year, with a further 25 per cent reducing their contribution levels significantly,” says Ciarán Phelan, director of financial services at the Irish Broker Association.

One of the main arguments made in favour of the abolition of top-rate tax relief is that the main beneficiaries are wealthy people who don’t need it. However the higher rate of tax kicks in at € 36,400 and, given that the average industrial wage is roughly € 33,000, a person does not need to be among the super-rich to benefit from this incentive.

“The vast majority of individual taxpayers who benefit from reliefs are not the super-wealthy but the 800,000 members of occupational pension schemes. Any changes to the tax relief system now will remove the only incentive available to those individuals to continue pension provision,” the IAPF said.

According to the Society of Actuaries in Ireland: “The current system gives the highest rate of income tax relief to people whose earnings are not too far above the threshold for the higher rate of income tax and who are saving a moderate amount for retirement.”

Furthermore, if tax relief at the marginal rate was removed, some taxpayers could potentially find themselves in the bizarre situation of receiving relief at the standard rate on their pension contributions, but being taxed at the higher rate when they draw down their pension. “For this group, to continue saving in this way is effectively partaking in a system of double taxation,” the IAPF said. “The result will be that they will save in vehicles that are unsuitable for long-term savings.”

In the last budget, the amount of salary on which an individual can make contributions and receive tax relief was capped at € 150,000, reduced from € 275,239. In addition, in 2005, a cap of € 5 million was introduced as the maximum value of a pension fund that could be funded out of tax-relieved contributions. This has been indexed and now stands at € 5.4 million.

Rather than slashing tax relief that is of most benefit to middle-income workers, a more equitable way of adjusting the system might be to restrict the amount of relief that wealthy people can avail of by lowering the € 5.4 million cap. In Britain, the equivalent cap is £1.75 million (€1.88 million). Ian Mitchell, managing director of Deloitte Pensions Investments, believes that is a “huge argument” in favour of applying a similar cap in Ireland “across the board” – ie the same cap should apply to public and private sector employees and the self-employed.

In fact, a radical overhaul of the current pension regime is required, he says, but not by cutting tax relief, as this would create a pensions “underclass” comprised of self-employed people and employees in very basic defined contribution company schemes.

Such workers are already seriously disadvantaged, he says. Unlike public service workers or employees in defined benefit schemes whose employers contribute the vast bulk of their pension, they must fund their retirement pot almost entirely themselves.

To illustrate the imbalance, Mitchell gives the example of a mid-ranked public servant who is 65, earning a pensionable salary of € 60,000 a year, and who has made pension contributions of € 80,000 over 40 years of service. That person will be entitled to receive a tax-free lump sum of € 90,000 and an indexed pension of € 30,000 when they retire. If all the circumstances were the same, except the individual was self-employed, the lump sum would shrink to €20,000 and their annual pension to € 2,400.

Such individuals need all the help they can get, he believes, and tax relief is the only support they have. “If really want to save money why target the self-employed?”

At the same time, the public sector won’t be too delighted if tax relief at the marginal rate is scrapped as it will increase the impact of the recently-introduced pension levy. At the moment a public sector worker on € 50,000 a year is subject to a pension levy at 7.5 per cent. However, after tax relief at 41 per cent is factored in, the net cost falls to 4.4 per cent. If the relief were to be reduced to the standard rate, the net cost would increase to 6 per cent. According to the IAPF’s calculations, the annual cost to such an individual would increase from € 2,200 to € 3,000.

Pensions Ombudsman Paul Kenny says he would be surprised if the Government moved on the pensions issue before the Commission for Taxation submits its report, which is expected in late summer. “That would be the sensible approach. At least then it’s not shooting in the dark,” he says.

Pensions savers and providers alike will be hoping that the rumours prove unfounded, and the Government waits for the recommendations of the commission rather than jumping the gun.