Pensions puzzle

The pension reforms announced by George Osborne were unquestionably the most significant aspect of the budget. After a few days, some of their implications are starting to emerge.

The chancellor framed the changes as a question of freedom. As he put it:

‘The tax rules around these pensions are a manifestation of a patronising view that pensioners can’t be trusted with their own pension pots.

I reject that.

People who have worked hard and saved hard all their lives, and done the right thing, should be trusted with their own finances.’

The case for

Alongside the in-principle case that the government should not tell you how to spend your savings (or technically, in this case, how and when you can receive them), there are some practical arguments as to why this new-found freedom might deliver better results.

– People may be willing to put more into a pot that is more flexible, knowing that they will be able to get at it when they want to/need it. More freedom to spend pensions might also therefore mean a greater willingness to store money in them.

– The structure of annuities, which produce regular payouts each year, doesn’t reflect the way people spend in retirement, which is ‘V shaped’. In other words, people tend to spend a lot at the beginning of retirement (having fun) and at the end of their lives (paying for care), with a spending ‘lull’ in the middle. More flexibility in how people invest their pensions could help address this.

– More choice will promote competition and therefore value for money. Telegraph columnist Janet Daley described the reforms as a ‘free market solution to the problem of annuity rip-offs, arguing that the reforms ‘insurance and investment companies will develop new products to court these liberated funds – and that annuity providers will have to up their game considerably if they want to keep their share of customers.’

The case against

Those who oppose the reforms have offered three types of responses:

– Paternalism. This is essentially is that to take George Osborne’s argument on its own terms and to disagree with him. The judgement freedom will do more harm than good: people will spend all of their money in one go and be left in penury. Either that, or the money will be left in bank accounts without the guaranteed long-term income that policies like annuities provide. James Lloyd, of the Strategic Society Centre wrote last week that, ‘the annuitisation deal is explicitly paternalistic: it ties people into doing what they otherwise might not want to, recognising that people make poor financial decisions’. Some economists, such as Joseph Stilgitz, argue that this attitude is more justified in pensions, where people have fewer opportunities to learn from past mistakes as we do with, say, buying a car.

– Moral hazard. This is the worry that people will spend all their pensions and then end up more reliant on the state to get by. However, the new flat rate state pension eliminates means testing, so people won’t receive more from the state if they spend their occupational pension. This is why Steve Webb, the pensions minister, felt able to comment that ‘if people do get a Lamborghini, and end up on the state pension, the state is much less concerned about that, and that is their choice’. Social care, by contrast, is means tested – but, because of the way the means test treats pensions, people may end up actually paying more, rather than less, for care if they cash in their pension early. That’s the policy – but the political question, raised by John McTernan among others, is whether pensioners are ‘too big to fail’: if a generation of pensions spend all their money, will governments really not step in to bail people out of poverty?

– Reciprocity. The argument here is that pensioners are not, in fact, simply spending their own money – because the state (and employers) have contributed significantly to them. Because of this, requiring people to invest pensions responsibly is justified as the other half of the bargain. Tom Watson MP has been making the running on this point, writing that: ‘When you pay into a pension the state doesn’t treat that like it does other income or even other savings – it gives you special tax breaks, special rewards and special protections.’ Will Hutton picked up the theme in this week’s Observer, noting that ‘Every citizen in these island pays higher taxes than they otherwise would to compensate for the lack of tax coming from tax-sheltered pensions.’ The risk is that the new version of the ‘annuity deal’ will be entirely one-sided: people will get the tax breaks but not the corresponding obligations.

The big questions ahead

I think all this raises (at least) two big questions.

1. What is the framework for policy on pensions now?

In many ways the Osborne reforms go with the grain of social change. Public and private sector organisations are (rightly) concerned with how to offer people more discretion, choice and flexibility about how to manage their affairs. But on the other hand, policymakers are also starting to recognise that the theory of choice is not enough to truly ‘empower’ people. People need the capacity to use choice effectively, including the skills and advice to make the choices right for them. Governments, meanwhile should recognise that while people are not stupid, we are human. This is the basis for ‘nudging’ in certain directions, without closing down freedom of choice all together. As George Osborne himself has put it:

‘Classic economic theory …[is] based on the assumption that humans always act in their own self-interest. But as we all know, humans aren’t always rational. We do things we know we shouldn’t, like eating too much or not saving enough.’

There is some irony that the most successful example of this kind of thinking is in…pensions policy. People are now auto-enrolled into occupational pensions, with the freedom to opt out, on the basis that inertia often gets in the way of what people might have chosen themselves. This is an explicit recognition that whilst government shouldn’t close off choice altogether, there is space in between top down prescription and outright libertarianism.

Where does that leave pensions policy now? How much advice will people really have access to (and of what quality?) Is advice alone enough? Could policymakers, for example, decide that people should be auto-enrolled into annuitisation by default? Or would that mean people getting even worse deals that many currently already get, without having thought seriously about the policy that is right for them? If not this, then what?

2. What does this mean for the tax system? 

The second (huge) debate I think this will open up is whether the current tax treatment of pensions can still be justified. The favourable tax treatment of pensions has been constructed  as part of a reciprocal deal with individuals, which requires pension pots to be invested in annuities so that they last throughout people’s lives.  If this obligation is removed, then can the favourable tax treatment really be justified? If people really want to buy Lamborghinis then why should other taxpayers (and employers) help pay for that? Opponents of the reforms argue that people should not to be given too much flexibility, because of the special treatment pensions get from the state. But once the reforms are in place, the question will switch to whether the special favours are justified, given the new flexibilities.

This has potentially huge policy implications. In one scenario, the Treasury might have its eye on billions of savings, through dramatically reducing the government’s contribution to pension pots. Employers, too, might question whether they too should be obliged to put into occupational pensions under the new system. Individuals might find themselves paying less tax, but with far less going into their pension pots. Alternatively, future governments might choose to revisit how they encourage saving (rather than how much), perhaps making tax breaks more conditional on people actively choosing certain types of products. Meanwhile, ambitious reformers might also open up a debate about the regressive way in which savings are treated by the tax system at present, with fundamental reform suddenly an option. The state may end up spending the same amount as it currently does, but in a completely different way.

In short, we are only just beginning to understand the policy and political implications of this announcement. The more threads you pull at, the more you realise that the current system could completely unravel. Who said budgets no longer matter?