Simplification is the key - Centre for Policy Studies

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savings by delivering a framework that is simple and flexible, permitting savers to make lifestyle choices with certainty. The recent Coalition Agreement (May 2010) does refer to ending compulsory annuitisation. 2.7 The unintuitive power of compounding Our inability to grasp the power of compounding has huge consequences for the size of our long-term savings, and consequently our wellbeing in retirement. It works both for and against us. This can be illustrated (Figure 6) by comparing the impact of four different tax regimes on the fund size of a basic rate taxpayer saving for 30 years, with and without an annual management charge of 1.5%. Figure 6: The power of compounding Pre-tax fund size at retirement £600,000 £500,000 £400,000 £300,000 £200,000 £100,000 EE ET TE EE 1.5% TT TE 1.5% ET 1.5% TT 1.5% • Basic rate taxpayer making contributions of 5% of salary for 30 years up to retirement. • Salary starts at £25,000, grows with inflation (2.5% p.a. long term). • Accruals: 50:50 income and capital gains. • Dividend income taxed at 10% (for both “E” and “T”), other income at 0% (“E”) or 20% (“T”), CGT at 0% (“E”) and 18% (“T”); blended rates 5% (“E”) and 14% (“T”). • Annual costs of 1.5% of fund size. Annual costs Accruals Contributions £0 0.0% 2.5% 5.0% 7.5% 10.0% Real rate of investment growth, p.a. Note that the focus of Figure 6 is the fund size at retirement. It does not consider the post-retirement realisation of assets and the different tax treatments of income in retirement; its purpose is solely to illustrate the pre-retirement power of compounding. EE (accumulation and accrual), for example, is inevitably followed by a “T” (i.e. income in retirement is taxed, as per a pension), whereas TE is usually followed by an “E”, as per an ISA. Thus the true value of the assets accumulated at retirement depends upon the tax regime applied to withdrawals, which Figure 6 does not reflect. Fund size growth accelerates as the real rate of return increases; this is caused by the power of compounding working productively. Figure 6 shows that the relative significance (and therefore cost to the Treasury) of any particular tax relief framework changes with the investment environment. In respect of fund size, tax relief on contributions (“front E”) becomes less significant relative to tax-exempt accruals (“middle E”) as the real investment returns rise; the cross-over between ET and TE is just beyond 19
a 10% rate of real investment return for basic rate taxpayers (and well beyond 10% for higher tax rate payers). Conversely, the deduction of an annual management charge has a devastating impact on fund size (and any annuity subsequently purchased): this is the power of compounding working against the saver. Extracted from Figure 6, Table 7 shows that the fund would be 30% larger without annual charges of 1.5% (assuming 5% real investment growth). Even with no real growth, the difference would be 24% (and 36% with real growth of 10%). Table 7: Annual charges and fund size (5% real investment growth) Tax treatment Fund size Fund size Charges as % (contributions, accruals) 0% charges 1.5% charges Charges of fund size EE £234,420 £179,968 £54,452 30% ET £209,463 £161,934 £47,529 29% TE £187,536 £143,975 £43,561 30% TT £167,571 £129,547 £38,024 29% One of the reasons behind this asset erosion is that charges are usually based upon fund size but, given the advances in IT, fund size is almost independent of the operating costs. A basic flat charge with additional charges linked to the number of different assets and transaction volume would perhaps be more appropriate, or a charge percentage that reduces as the size of the asset pot increases. Successive governments have used the power of compounding to their advantage. In 1993 Norman Lamont first cut tax credits on share dividends paid into pension funds, a move completed by Gordon Brown in 1997, when he scrapped the remaining 10% rebate on dividends. Estimates vary as to how much the Treasury has subsequently benefited, with a corresponding reduction in the value of retirement funds, but one report puts the figure at between £150 billion and £225 billion, 61 to the detriment of millions of savers and pensioners. 2.8 Start saving early It clearly pays to start saving early. Figure 6 is based upon 30 years of consistent saving, which produces a fund more than three times larger than 15 years of saving would have produced: 62 the power of compounding working to the saver’s benefit. The importance of catching the saving habit early is reinforced by Figure 7, which shows that the persistency of non-savings behaviour increases with age. Once past the age of 40, nonsavers become more determined not to start saving; the non-saving mindset becomes ingrained over time. 61 62 The Taxpayers Alliance, The UK Pensions Crisis, November 2008. Assuming a 5% p.a. real rate of investment growth, with tax relief on contributions and exempt accruals (EE). 20
Page 1 and 2: Simplification is the key Stimulati
Page 3 and 4: THE AUTHOR Michael Johnson trained
Page 5 and 6: A note concerning data Finding a co
Page 7 and 8: These proposals depend upon having
Page 9 and 10: SUMMARY The UK’s long-term savin
Page 11 and 12: any annuitisation requirement, prov
Page 13 and 14: Thus, had pension savings products
Page 16 and 17: INTRODUCTION There has been a flood
Page 18 and 19: PART ONE: THE LONG-TERM SAVINGS LAN
Page 20 and 21: Japan’s savings ratio was once th
Page 22 and 23: scheme contribution rates are lower
Page 24 and 25: Table 1: Funded pension scheme asse
Page 26 and 27: 1.9 The international perspective A
Page 28 and 29: Table 4: ISA savers’ income distr
Page 30 and 31: Table 6: The complexity of the tax
Page 32 and 33: Figure 4: Income options upon retir
Page 36 and 37: Figure 7: When non-savers might sta
Page 38 and 39: There are other aspects to consider
Page 40 and 41: 3. THE EMPLOYERS’ PERSPECTIVE 3.1
Page 42 and 43: When employees with DC funds retire
Page 44 and 45: More specifically, employers are no
Page 46 and 47: Both businesses do have important c
Page 48 and 49: year. 91 Clearly, there are conside
Page 50 and 51: elderly and the wealthy, not least
Page 52 and 53: 5. THE TREASURY’S PERSPECTIVE 5.1
Page 54 and 55: Whilst the UK’s NRR for the mean
Page 56 and 57: Currently, reducing pensioner pover
Page 58 and 59: Table 13: Net cost of tax relief un
Page 60 and 61: TEE would be hugely attractive to p
Page 62 and 63: 5.6 Tax treatment: international pe
Page 64 and 65: PART II THE PROPOSALS AND THEIR IMP
Page 66 and 67: Proposal 6: post-retirement, amend
Page 68 and 69: 7. TAX SIMPLIFICATION: SOME OPTIONS
Page 70 and 71: 8. THE IMPLICATIONS FOR SAVERS Impl
Page 72 and 73: The higher rate taxpayers’ perspe
Page 74 and 75: segregated from any employer-sponso
Page 76 and 77: epresent a further step down the pa
Page 78 and 79: 10. THE IMPLICATIONS FOR THE PENSIO
Page 80 and 81: Such principles would have to ensur
Page 82 and 83: Figure 13: The cost of pension savi
Page 84 and 85:
pool of underlying pension assets (
Page 86 and 87:
hardship” facility, whereby cash
Page 88 and 89:
occupational pension scheme benefit
Page 90 and 91:
CONCLUSION We would save more, for
Page 92 and 93:
ACKNOWLEDGEMENTS This paper was cat
Page 94 and 95:
APPENDIX I Summary of proposals fro
Page 96 and 97:
APPENDIX II Value of assets in priv
Page 98 and 99:
depending upon age at the time that
Page 100 and 101:
APPENDIX V PRE-RETIREMENT ACCESS TO
Page 102 and 103:
APPENDIX VII FINANCIAL PLANNING TOO
Page 104 and 105:
APPENDIX VIII THE MODEL 173 The
Page 106 and 107:
GLOSSARY Alternatively Secured Pens
Page 108 and 109:
pensions and earnings, but excludes
Page 110 and 111:
those with earnings above £4,940 b
Page 112 and 113:
in cash terms, i.e. fixed at £770
Page 114:
The UK savings industry is barely t
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