In order to encourage retirement saving in Britain: should we place more emphasison traditional tax incentives, or on how we ‘frame’ retirement saving opportunities, such as the specification of ‘default options’ in levels of saving?
What is a pension?•A regular payment made to a person during their years ofretirement•Pensions allow an individual to smooth consumption acrosstheir life-time, sacrificing consumption in working life forconsumption in retirement years
Retirement Saving• Pensions are an insurance against an uncertain length of life.• The insurer guarantees a regular payment to the individual until death.• In return for a contribution (or tax payment), the insurer is taking over the longevity risk i.e. risk pooling• A risk averse person would save too much.• A myopic person would not save enough and regret it later.• Pension programmes may also have other insurance features (e.g. insurance against loss of earnings due to retirement through disability)
•The two main types of pension are Defined Benefit (DB) and Defined Contribution (DC) •The Guardian defines the two as follows:D e f in e d B e n e f it D e f in e d c o n t r ib u t io nAlso known as a final salary scheme. The Also known as a money purchase scheme.amount of income an employee receives The level of contributions made by theon retirement is defined - or decided - in employer (and, frequently, the employee)advance, based on the number of years he are set, but the amount of income receivedor she has worked for an employer and the on retirement is not.level of their salary when they retire. The contributions are usually set as a percentage of salary. A defined contribution pension scheme is set up by the employer, and he or she must contribute to the scheme.
Private Pensions• Defined Contribution:• An individual has a contract with a provider (insurance company, a corporate pension plan etc.)• He or she (and perhaps their employer) contribute to the pension plan.• The contributions accumulate in a pension fund.• At the date of retirement, the pension fund is converted into an annuity. The annuity is paid until death.• Working out the annuity rate is what actuaries do.
Private Pensions• Defined Benefit:• Employers offer a plan which spreads the incidence of risk• This offers a target pension benefit at a given age, linked to years of service and a measure of salary• Pre-commits pension fund to a certain pension level on retirement, and, so doing, shifts some investment risk from the individual to employees in general (by e.g. varying contribution rates)• Annuity value doesn’t simply depend on the individual’s fund performance• Employers may do this to attract better quality workers, or to retain workers and thereby avoid turnover costs • Different employers offer DB and DC plans. Some do not offer any plan. • DB plans are common in public sector • Many private sector employers are phasing out DB plans in favour of DC plans • In UK terminology, employer-provided pensions are called occupational pensions • Pensions bought by individuals from insurers are called personal pensions.
Public Pensions• Governments also offer near-universal pension programmes, which are not just for public sector employees.• The programmes are typically of the defined benefit type• They can pool risks across individuals within generations, and also between generations• In the ‘Bismarck’ system (e.g. continental Europe) programmes offer comprehensive earnings replacement - little private pension coverage)• In the Beveridge/Anglo Saxon system, social security is a floor (minimum income), with either compulsory or mandatory private provision on top. This is called the ‘multipillar’ system• Typically, social security is largely unfunded or ‘Pay as you go’ (PAYG) i.e. no fund is accumulated and current contributions pay for current pensioners.
Public Pensions• Redistribution to the poorest• Myopia (people don’t save enough) – but who defines ‘enough’ ? + presence of social security distorts saving decisions• Market failure – private insurers cannot ‘risk rate’ efficiently – people alter their behaviour after signing the contract• Administrative costs – private-for-profit may be more expensive – economies of scale in administration
The current issues facing pension provision• Ageing population• Low rates of private saving• The mis-selling of personal pensions in the late 1980s has created low confidence• More recently, a collapse of a large number of company final salary pension schemes Data shows that there is a danger that people will face inadequate pensions without high value assets or a later retirement age
Problems• People are living longer – and longevity improvements have often been underestimated by official actuaries• People have been retiring earlier – wealth effects in private schemes, political decisions in social security• Fertility rates are low, in most OECD countries below ‘replacement’.• In social security programmes, political limits on raising taxes, institutional limits on raising debt – e.g. EU Stability Pact
Problems• With largely public provision (‘Bismarck system’), future taxpayers may not pick up the bill• Therefore pension generosity will have to be cut sharply, or people retire later• With multi-pillar systems, less ‘policy risk’ for publicly-provided segment, but exposed to ‘investment risk’• Might ageing affect capital markets (more dissavers, fewer savers, so asset prices fall?)• Are there feasible reform strategies and/or can markets adjust (e.g. incentives to retire later)?
Current Trends in UK pensions• One article (BBC ) showed that despite fluctuations in private sector pensions, the deficit of £271bn recorded at the end of December illustrated that the cost of pension provision has risen significantly in recent years• Other evidence suggests that the prospects for public sector pensions are also dismal. Strikes were held in November 2011 over government plans to reform public pensions which included increasing the retirement age and increasing worker contributions• Consequently, it appears that pension provision is a very controversial issue concerning the UK today.• This presentation aims to discuss these problems in more detail and examine the optimal methods for providing retirement pensions in the UK
Traditional Tax Incentives 16
“Granny Tax”• The change in age-related personal allowances - the amount of income that is tax-free - will save the government £360m in 2013-14, rising to £1.25bn a year by 2016-17.• If you are aged 65 to 74, then you get a bit more of an allowance. The first £10,500 is tax-free from April.• Most significantly, those who hit 65 just after April 2013 will not get the tax- free allowance they might have expected.• HM Revenue and Customs (HMRC) says this will bring an extra 230,000 into the income tax system. For many, this will mean having to fill out a self- assessment tax form every year.• Figures from HMRC show that, taking inflation into account, this will leave 4.41 million people worse off than they would have expected, by an average of £83 a year in 2013-14.