The Sunday Independent reports that an important debate is taking place within the Commission on Taxation:
“But its report may also call for a reduction in tax relief for ordinary private sector pension-holders and a “fierce argument” is raging within the commission over the €2.9bn cost of this relief versus the incentives that it gives to provide for the future.”
The idea of limiting tax breaks on pension contributions has received a good deal of attention, with Fintan O’Toole a notably vocal advocate (see here). This focus is understandable given that the better off are the primary beneficiaries of the tax breaks.
The fact remains that many households – even better off ones – are not saving enough to sustain their living standards in retirement. This is compounded by staggering losses in both defined contribution and defined benefit pension plans. (See Brendan Walsh’s post from December on the crisis in occupational pension plans.)
The tax incentive can be viewed as a device to overcome the inertia that keeps people from making adequate pension provision. As such, I would agree that it is not particularly efficient. But it is encouraging to see that at least some on the Commission believe it is important to approach pension reform in a comprehensive manner rather than simply eliminating the existing incentive.
The Green Paper on Pensions looked at the possibility of moving to some sort of mandatory or “soft mandatory” (with default) contributions to retirement savings accounts. Unfortunately, with households being squeezed from so many different directions, it is hard to see from where they would find the money. In a post a few weeks back, I proposed the idea of a Swedish-style system of unfunded – or “notional” – defined contribution accounts that could at least reduce the pressure for other tax increases.
What is most important is that reforms take place in the context of an overall plan for the retirement income system. The complexities and importance of pension reform are such that it should not be driven solely by short-term fiscal considerations.
11 replies on “Tax breaks for pensions”
There is also the issue with regard to the pension providers. In general their fees are high, opaque and returns are lousy. Take away the tax break and you are better off having your money on deposit. In many ways the tax break is a subsidy for the private pension providers.
The tax break is about all that makes most PRSAs financially viable for most people.
A basic nationalized pension scheme based on solidarity principles is about the only way of overcoming these issues.
If there were such a scheme then tax breaks could be reduced or eliminated for additional pension saving.
Have to agree with FPL. The pension providers rarely even match the market and the only reason not to do it yourself is the tax breaks. Reduce these and the incentive to use pension providers vanishes. There must be other ways to incentivise long term savings.
Would a long term SSIA type system work? The government automatically adds 10% say per annum for each €100 invested. It would be cheaper than the tax breaks and the same for everyone even if they pay no tax at all. There would have to be a minimum term – could be 20 years +. People could choose if they wanted a straight deposit or go into equities. The government could place a cap on the amount invested that would attract the extra 10%.
Someone therefore on €40k today say investing 5% of their salary plus 5% from their employer puts in €4k per annum. The government adds another €400. Assuming 3% pay rises on average, on deposit at 4% per annum for 20 years compound gives a lump sum of c€169k at the end of 20 years and €676k at the end of 40 years. Could even create a government bond to invest the money in paying 4% per annum.
Every PRSA I see at the moment is in the toilet. I can see a lot of people going for a safe guaranteed return. Could even make it mandatory for a minimum level to be invested.
Am I missing something?
Would anyone like to comment on Shane Ross’ attack on borrowing 1.6 billion to put into the national pension fund (see http://www.independent.ie/opinion/columnists/shane-ross/the-slush-fund-for-failures-1665066.html)
Fintan O’Tooles figures were inaccurate, so to a degree the storm building around his statements are equally pointless, but regarding the ‘pensions bubble’ we’ll face in the future:
Would it be the most sensible approach to put aside a certain portion of the tax we pay into an account which is specifically for retirement? The individual could decide how it is invested but participation is mandatory, how we can have generation after generation go through life without funding for retirement is an indictment upon the structure of our taxation system more than anything. Granted there is a squeeze in every direction at the moment, but the current economy only demonstrates all the more graphically that we are doing it wrong so far. PRSA’s didn’t have the expected take up, so the only other option is to remove state benefits entirely or make contribution mandatory. in 2036 there will be 2 people working for every pensioner, there is no realistic way to expect the current plan to work out happily ever after.
@FPL I share your concern about the high expense ratios for most private funds. Athough views certainly differ on this, mine is that most expensive money management is typically money down the drain. If we ever go the route of funded accounts, the menu should be dominated by low cost options, with a very low cost (and low management) default. Needless to say, we can anticipate political opposition given the vested interest of the financial services industry.
@Stuart I agree with the general thrust of your suggestion for a system of SSIA-style individual accounts. (I would probably allow more choice over asset allocation, but with a low cost, low risk default option). With such a system in place, it would then be desirable to remove the expensive and regressive tax incentives.
In the current climate, think the chances of the government subsidising investments or mandatiing contributions to funded accounts are low. That is one reason why I have suggested introducing an unfunded defined contribution individual account system. The return on these accounts would be equal to the growth in the wage bill. Later, a funded accounts could be added, providing a multi-pillared and thus better diversified system of of retirement income provision. Unlike an immediate funded option, introducing the unfunded accounts would lead to an immediate, large and long-lasting flow of revenue to the exchequer.
@Paul. Thanks for the link to the Shane Ross article, which I had missed. I am probably in a small minority on this, but I think continuing to invest in the NPRF is a very good idea. My sense is that a large part of the default risk perception stems from the tail risk of a bank run type funding crisis: highly risk averse creditors flee because they fear others are fleeing (why take the chance?). A large liquid reserve makes this descent into a bad equilibrium much less likely to happen. At the moment, the NTMA seems to have little difficulty finding takers for Irish bonds. Even if the funds are invested in German bunds, I think the interest rate differential is a price worth paying for liquidity on the asset side of the national balance sheet.
Thanks for your reply John. Your approach is not one that comes intuitively to non-economists. Would it not be better to suspend payments for a couple of years until the current upheavals have ended, perhaps with a legally-binding commitment to make extra payments in 2011/12 to make up the shortfall even if that means extra borrowing in those years? As part of a plan to stabilize the government’s finances this deferred borrowing might benefit from a fall in the interest rates we have to pay for it compared to current rates?
I think this is fascinating and agree with a lot of what has been said. I find that the pension providers get away with very being customer unfriendly thanks to a large extent to the tax relief that gives them a huge carrot to hide behind. I also think it is telling that (a) either the public servants don’t grasp the value of the pensions they have or (b) they doing their best to minimise any erosion of their hard won increments. I would like to see a leveling of the playing field in terms of public/private pension entitlements and visibility. Of course the politicians have the greatest vested interest of all in this space making an equitable resolution seem even further out of reach.
“The tax incentive can be viewed as a device to overcome the inertia that keeps people from making adequate pension provision”. It could more accurately viewed for what it is, namely income redistribution to those who pay the most tax (directly at the expense of the general taxpayer).
Ciaran:
For ordinary people it’s only getting back tax that have already paid. And when the pension starts being paid at retirement they pay tax on it.
Paul: Maybe you miss Ciarans point, or maybe I miss your point. This tax is avoided completely – not just deferred until retirement -by a couple of mechanisms, which seem designed for exactly that purpose, and are of course out of reach of lower paid.
1. The use of AVCs to fund a tax free lump sum at retirement. Because of the variation between annuity rate (variable but very low right now) and commutation rate (usually fixed and high) this is a much cheaper way to do this than taking a reduction in pension.
2. The use of ARFs as a continued method to avoid the ultimate tax which would be payable if it were converted to annuity – this is referred to in Fintans article.
I don’t think anyone would be encouraged to contribute to AVCs for example if it were just a matter of deferring tax until retirement.
I do agree with you that ordinary people will pay tax at retirement later. This is one reason why I think PRSAs for ordinary people are just a bad idea. Another is the cost of funding an annuity at retirement here is an example which was given me recently (source was Irish Life):
.”..the purchase price would be €496,184.00. This would provide a pension of €10,000 per annum..”
That is almost €500,000 for 10,000 pa. Putting this sum on deposit would obviously give a better annual return, while retaining the initial capital, but putting it on deposit is not an options for PRSAs. I think it must be converted to an annuity. Maybe I’m wrong?
Aidan:
The original “inertia” point applied to everyone. Indeed I would think it would apply more to those with lower incomes, who would not be financially sophisticated.