Moment of truth is fast approaching on pensions
OPINION:The Government must resist pressure to curtail tax relief on pension contributions if a crisis is to be avoided, writes PAUL O'FAHERTY
THIS MONTH it was the “Bord Snip Nua” report. Next month we will see the report of the Commission on Taxation. Together they will form the backdrop for Government discussions and public debate in advance of a very, very difficult budget.
There is pressure – justified in many cases – to curtail various tax reliefs and allowances and the Commission on Taxation will undoubtedly have views on many of these. One change that should be resisted is the reduction of tax relief on pension contributions. Doing this to help resolve today’s fiscal problem would simply store up another fiscal problem for the future.
The Government has already seen this potential problem coming. In 2000, the Government acted to face up to a pension crisis that was appearing on the horizon. The population was ageing and living longer, private pension provision was well below what it needed to be and it looked as if the State would face major difficulties in meeting its pension requirements by 2025.
As part of its response, the Government set up the National Pension Reserve Fund to which 1 per cent of GNP was to be paid each year to try to offset the 2025 problem.
Nine years on, what has changed? Virtually all pension funds have seen hopefully temporary but substantial reductions in their value as a result of the sharp decline in equity prices. Individuals and companies are struggling to make pension contributions because of the effects of recession.
Defined benefit pension schemes are facing grave difficulties. The pension reserve fund itself has been diverted from its long-term strategy and is now helping to fund the recapitalisation of the banks.
The only thing that hasn’t changed is the basic demographic fact that underlays the establishment of the pension reserve fund: we have an ageing population and, from 2025 onwards, the State will face a major challenge in meeting its pension obligations.
There has been one more change. In 2001 when the fund was set up, 2025 was 24 years away. Now it is just 16 years away. When the economic and banking crises end, as they will, we will still face the problem of how to fund pensions for a population that will live longer than any previous generation, but that problem will be closer.
The State cannot be expected to fund pensions for everyone. Private pension provision for those who can afford it offers the only prospect of alleviating the burden on the State.
To ensure as many citizens as possible provide for their own retirement, they must be encouraged to make regular payments into pension schemes. The taxation system is central to ensuring this happens.
Now more than ever, tax relief on pension contributions and investment income and gains should be maintained at the marginal rate.
There is an easy argument made currently that tax relief on pension contributions currently “costs” the exchequer €3.2 billion. This is misleading, though: once a pension fund is being paid out during retirement, income tax is then paid on it, so what is called tax “relief” is in fact only tax deferral.
It is this deferral of tax that makes saving for retirement worthwhile for individuals.
There have also been claims that the current pensions regime is regressive – that it favours higher earners over lower earners. However, because both pillars of our pensions system – State pensions and private pensions – are inextricably linked, both must be taken into account when assessing whether the system is fair or not.
The reality is that the State pensions are hugely subsidised by higher earners – and few would argue with this principle – and this far outweighs any benefit these earners gain through the tax treatment of private pensions.
Also, any move to tax the investment gains of pension funds as they are earned would be double taxation, as investment income and gains are already taxed when pensions are paid. This would not be consistent with the goal of “increasing the fairness of the tax system”.
There are aspects of the current system which are seen as unfairly favouring well-off individuals. Take the advantages currently received by those fortunate enough to be able to put their pension fund into an Approved Retirement Fund (ARF) on retirement. Typically (although not always), such funds are availed of by the relatively well off. People can effectively accumulate substantial wealth within these funds and then take large tax- free lump sums out of them later.
This is not fully compatible with the concept of deferred taxation. In these cases, an individual may have made tax-free contributions to their pension fund and then may have been able to use the ARF mechanism as an inheritance-planning device. This is something that could be addressed to ensure fairness and equity.
For example, a reasonable cap could be placed on tax-free lump sums at retirement and the proportion of an ARF that must be distributed each year could also be increased.
In relation to distributions from ARFs, a report by the Department of Finance in 2005 found that 89 per cent of ARFs were not being used to provide income and concluded: “ARFs have allowed the diversion of retirement provision into simple tax-advantaged savings schemes for those who do not need them to produce a regular income stream.”
Therefore, provided marginal tax relief on contributions and full tax relief on investment income and gains are maintained, the current requirement to automatically draw down at least 3 per cent of the ARF annually should be doubled to 6 per cent for funds above €150,000.
Pension provision is currently facing substantial difficulties and the clock is ticking steadily towards the time when Ireland’s current substantial underprovision for retirement will be very badly exposed. In this context, the introduction of a new 1 per cent levy on insured pension arrangements from 1st August is not helpful at this time.
Any further reduction in the tax advantages of providing for retirement may turn a serious problem into a crisis. It could deal a fatal blow to private pension provision, which in the end will increase reliance on the State.
Paul O’Faherty is the chief executive of Mercer and the author of the company’s recent paper on the tax treatment of pensions, Position on the Taxation of Pension Schemes in Ireland.