As the UK government consults on pensions tax incentives, what could happen if “Pensions ISAs” replaced the current system? It would be very helpful if such an experiment has been tried somewhere else – and happily, New Zealand provides.
During the late 1980s and early 1990s, the New Zealand government radically reformed its economic and social institutions. Markets were deregulated and privatised; the financial sector was liberalised. The tax system became flatter and simpler, and tax neutrality – including that no savings vehicle should be taxed differently than any other – was seen as A Good Thing.
Following this philosophy, between 1987 and 1990, the tax framework for pension schemes changed from
- EET: contributions being Exempt from tax, investment returns also Exempt and pensions proceeds being Taxed,
- TTE: contributions being made from Taxed income, investment returns being Taxed, but when proceeds are drawn they are Exempt (1).
This would be similar to switching the tax framework for UK pensions to that for Individual Savings Accounts (ISAs) – the UK government is currently consulting on whether to do this.
So what happened when New Zealand switched? There’s no doubt that pension schemes suffered. Just after the reforms, 22.5 per cent of the workforce were in an employer-sponsored scheme but only 14.6 per cent were by the end of 2001. However, contemporary accounts offer reasons other than purely the tax change for the decline in employer-sponsored pensions (2):
- Questions about the value of pensions as useful in retaining and attracting staff
- Harder economic times and reduced scheme surpluses
- Technical issues with taxation which made schemes less effective for lower earners
- Change in type of schemes from Defined Benefit to Defined Contribution with many reducing in value
- High compliance costs
Many of these trends happened elsewhere. They may have had more impact on New Zealand workplace schemes because New Zealand has relatively few large employers. And while personal pensions were available in the UK, there was then no such option in New Zealand.
So was the tax reform in New Zealand a bad thing? Long-term, the answer seems to be no:
- The tax reform caused no obvious impact on New Zealand’s savings rate. Economists can argue over the data, but total household savings are subject to more trends and cyclical effects than the pensions tax regime alone.
- The continuation of tax neutrality has had support from every relevant review in New Zealand on retirement income, saving or tax policy. While industry and employee advocates sometimes call for a return of incentives there has never been any sustained enthusiasm from policy makers (3).
Added to that, we are in a different world now.
- Auto-enrolment with compulsory employer contributions now does the heavy work of getting workers into pension schemes, in both New Zealand and the UK. The success of KiwiSaver deserves another post; suffice to say that many more people now have some pension saving than was the case before the tax reform.
- The new state pension in the UK means less means-testing, so the government is less interested in ensuring you take pension savings as income than it was under the old regime. This makes the UK more like the New Zealand situation where a decent state pension is practically universal.
Would pensions ISAs be bad policy for the UK? New Zealand experience suggests that the sky wouldn’t fall in. However, the UK has always had more private pension provision than New Zealand, with higher tax incentives and a more vocal political constituency. A change would be even more of a shock in the UK than it was in New Zealand. Is such a shake-up needed? Reducing the cost of tax incentives, and changing the distribution of who benefits, could be achieved simply by revising the current system.
(1) Michael Littlewood (1998) How to Create a Competitive Market in Pensions: The International Lessons, IEA Health and Welfare Unit
(2) ASFONZ (now Workplace Savings) (2003) Submission to the Periodic Reporting Group. PDF
(3) Peter Harris (2012) New Zealand’s Retirement Income Framework: trends, continuity, change. A background paper prepared for the 2013 review of retirement income policy. Commission for Financial Capability. PDF