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What do pension tax reliefs actually achieve?
“Pensions do not exist to increase national savings or to provide jobs for actuaries, tax lawyers, accountants, fund managers and regulators. Their purpose is to allow the elderly and disabled to retire from work with dignity”
- United Nations Department of Economic and Social Affairs (2000)
Typically, the argument in favour of tax relief on contributions to private pensions revolves around the need to encourage retirement savings.
The arguments often cited for why we would want try to incentivise pension savings usually revolve around two strands:
- The need to ensure a reasonable continuation in the standard of living of people once they retire and to reduce people’s reliance on the state in retirement;
- The need to reduce the financial burden on the state.
Let’s look at both of these in turn.
1. Maintaining living standards in retirement
This sounds like a good idea.
Back in 1998 the Pensions Board’s National Pensions Policy Initiative set a target of ensuring that a combination of pensions from all sources (State and occupational or private pensions) were adequate to cover 50 per cent of an individual's pre-retirement income. 50 per cent is an arbitrary target, but for now let's work on the basis that it is a sensible one.
A 2014 study by Collins and Hughes found that taking the median contribution to a private pension - calculated by them to be €3,300 per annum - as an example, contributing to a pension for 40 years will provide an annual income in retirement of approximately €5,200. Combined with the prevailing State Pension, this gave a replacement rate in 2014 of 37.5 per cent for a median pension contributor. So the median contributor should be expected to achieve about 75 per cent of the target.Is this a problem?
Research by TILDA indicates that retirement income replacement rates were not associated with quality of life after retirement. Instead they found that it is actual income in retirement, rather than the proportionate change in someone’s income from that received before retirement, that most affects quality of life. TILDA found that all aspects of quality of life, including control, autonomy, self-realisation and pleasure, increase consistently with household income. That's actual income, not proportions of previous income. This would suggest that policies aimed at achieving a certain rate of replacement to pre-retirement income should not be given as much priority as policies seeking to achieve a minimum income floor for retirees – something that the State Pension is best positioned to provide.
With this in mind, and given that the purpose of any country’s pension system is, as alluded to in the quote at the beginning of this article, to allow the elderly and disabled to retire from work with dignity, then it would make sense that the vast majority of resources within the system be allocated to providing a flat-rate universal pension to all those over the State Retirement Age, and maintaining it at a level which allowed retirees to achieve what might be considered a socially acceptable standard of living. Social Justice Ireland has costed just such a proposal. Read more about it here.
It is also worth noting that the Collins and Hughes example above reflects the situation for the median contributor. Given that less than half of private sector workers are contributing to a pension, this is a long-way from being the median citizen or even the median employee. Private pensions assist too small a proportion of the population, and the even most of those they assist end up with replacement rates that are inadequate by the standards being set. The State Pension is best positioned to provide a minimum income floor for all our elderly.
2. The need to reduce the burden on the state
This is the argument most often cited in favour of incentivising private pension savings.
We’ve heard it in different forms, but it usually sounds something like this:
- The number of older people in our society is increasing.
- The ratio of workers to pensioners is going to decrease significantly in the coming decades.
- As a result, the cost of paying the State Pension to those past the State Retirement Age will become unsustainable.
- Private pensions is part of the strategy for reducing this burden on the state and the best way to encourage people to save for their retirement is through the aforementioned tax reliefs.
This sounds very logical, until you examine it further.
One of the features of the Irish State Pension is its connectivity to the labour market. Eligibility for a pension from the State is based on one of two strands:
- Social insurance contributions (PRSI);
- Means testing.
In other words, you qualify for a State Pension in Ireland on the basis of your labour market history and payment of social insurance contributions, usually over several decades, or you qualify based on a means test that shows that you do not have the financial means to provide for yourself in retirement.
In theory, encouraging people to save for retirement will help reduce their reliance on the State and therefore the financial burden to the exchequer of paying these pensions will be reduced. But here’s the thing….
Saving for a pension is expensive. As a rough rule of thumb, every €25 saved will buy a pension of about €1 per annum for a man aged 66 (the current State Retirement Age). And that’ll be a flat pension which will not increase, even though the cost of living will almost certainly increase over time.
People who can afford to save sufficient amounts of money over a long period of time to buy themselves a decent pension are almost always in the labour force for several decades, so are almost always the same people who will qualify for a full - or close to a full - State Pension (Contributory) based on their PRSI history. They will also have received thousands of euros – indeed more likely tens of thousands of euros – in tax relief over many years.
This is allegedly with a view to saving the State money when they reach retirement. But the fact that they may have saved a medium-to-large pension pot and so can afford a decent annuity will not reduce the cost to the State. On the contrary, these same people will now likely qualify for a full State Pension as well.
Yes, the individuals involved will be reasonably well off, and certainly much better off in their retirement than had they not saved: they will have their State Pension (Contributory) – currently a little less than €13,000 per annum – and whatever money they are receiving from their private pension which was semi-funded by other taxpayers through the generous system of tax relief currently being implemented. But let's be clear: the saving to the State is exactly zero.
How about those who receive a means-tested pension; the State Pension (Non-Contributory)? By definition, they have not qualified for the State Pension (Contributory) due to insufficient PRSI payments, nor have they the necessary financial means to achieve a decent standard of living in retirement. Given that they have insufficient PRSI contributions, it’s safe to assume that their connectivity to the labour market over the preceding decades has not been particularly strong. They were therefore, for the most part, not in a position to avail of the tax-based incentives to contribute to private pensions as they had little or no income for the majority of that period.
Again, the incentivisation of private pension savings has produced no saving for the State among this cohort, who are now in receipt of the State Pension (Non-Contributory).
What we do know about the distribution of private pension savings and the associated reliefs is this: more than 70 per cent of the relief granted to private pension contributions accrues to the top 20 per cent of earners.
It seems highly likely that, given that the opportunity cost for someone in the top income quintile to leave the workplace for a significant period of time is quite high, the majority of such recipients will qualify for a State Pension in retirement as well, with reasonably complete PRSI histories.
It is time to face facts and identify pension-related tax reliefs what they are: an expensive means of subsidising retirement savings for the better off in society, with little or no financial benefit to the State.
Yes, it should be acknowledged that, given that pensions are taxed in retirement, the exchequer will receive money back at some point. However, a significant proportion of those who receive relief at the higher marginal rate (currently 40 per cent) will pay tax in retirement at the lower standard rate (currently only 20 per cent), while many – regardless of which rate they received the relief – will have retirement incomes so low they will pay no tax at all.
The current incentive system for private pensions has a very high fiscal cost, yet is currently failing to meet its targets in relation to coverage and income adequacy in retirement. The arguments in favour of continuing this perverse incentive system do not stack up. There is little to no fiscal benefit to the exchequer in either the short or the long term, unless the eventual aim is to slowly erode the value of the State Pension over time and force people to rely on their private pension savings - something that should be strongly opposed.
The best use of the resources already available to the Irish pension system would be to direct them towards funding a flat-rate unviersal pension payment from the State that would ensure that older people can retire with sufficient income to live life with dignity and without the prospect of exposure to poverty in their retirement.