How to save
Time for another pensions revolution
If we did not know it before, we do now: pensions are for old people. For the past two years we have become used to big, surprising announcements on retirement saving in Chancellor George Osborne’s Budget statements and his latest continued that tradition. From April 2017 anyone under 40 will be able to open a Lifetime ISA, a savings vehicle that will, Osborne promised, solve the financial dilemma that today’s younger people face—do I save for a house deposit or for my retirement?
The Lifetime ISA will allow people to put in up to £4,000 every year and, until they reach the age of 50, for every £4 they put in, the government will add another £1. Once they reach 60, they will be able to withdraw the whole amount tax-free as and when they wish. But if they decide they need to get their hands on the money earlier than that to fund a deposit on a property, they will be able to do so.
This, above all, is a very astute piece of marketing. The Lifetime ISA directly targets younger people with a product that is explicitly not available to their parents. The young, Osborne told the House of Commons, find pensions complex and inflexible. Instead he has offered them a savings vehicle that is simple, provides a straightforward Buy-Four-Get-One-Free bonus from the government and does not compel them to lock away their money for 30 years or more.
If you look a few years into the future, it seems entirely plausible that many young people’s first move will be to put as much as they’re able into a Lifetime ISA each year, and only turn to a workplace pension that comes with contributions from their employer once they have done this, in order to salt away anything further that they feel they can spare. For the younger self-employed—who cannot in any case benefit from employer contributions—the whole idea of saving into a pension has just become a great deal less relevant.
The idea of an ISA explicitly linked to retirement saving has been around for quite a while and was most recently subsumed into the Pension ISA proposal that the Treasury consulted on following the last Budget, as part of a series of possible reforms to the current system of tax relief on pension contributions. Although Osborne clearly liked the Pension ISA concept, the Treasury eventually concluded that it would be too disruptive to introduce as originally envisaged. So instead, he came forward with the Lifetime ISA. This sits squarely in the same tradition as his previous pension reforms—promoting the idea of individual choice and flexibility instead of the aura of compulsion and inflexibility that has dogged pensions for decades, but now with the added twist of an appeal to the concerns of younger savers with multiple financial goals to think about.
“For the younger self-employed, the whole idea of saving into a pension has just become a great deal less relevant”
It looks like the Pension ISA is to be introduced gradually and under a different name, enabling Osborne to steer the pension system in the direction he believes it should ultimately go, without causing immediate upheaval and revolution. Instead, the two systems—pensions and Lifetime Isas—will have to compete for the affections of the young: one offering top-up payments from both the government and their employer but no access to their money until they retire, the other offering a top-up only from the state but allowing them much more flexibility in how and when they use their savings.
Put this way, the attractions of the Lifetime ISA are obvious and it will doubtless prove popular.
Its introduction also sends some very suggestive signals about the government’s long-term direction of travel on pensions. For a start, it indicates that pensions will no longer be the only way to save for old age that attracts a financial incentive from the state. Indeed, the Lifetime ISA looks like a “proof of concept” exercise for a possible shift to the ISA model for all retirement saving sometime in the future. The clever part is that Osborne is letting the market reveal which route people prefer and by how much.
This announcement also suggests strongly that reform of tax relief on pension contributions has not been taken off the table, merely postponed. It seems plausible that pension tax relief could shift to a flat rate, perhaps 25 per cent, in the fairly near future, thereby giving basic rate income tax payers a bigger pension boost than they get now, while also cutting a big slice off the amount handed out to higher rate taxpayers. This would reduce the government’s £35bn-plus annual bill for pension tax relief, while at the same time giving a bigger subsidy to pensions than to the Lifetime ISA—what you lose in flexibility with a pension, you gain in a bigger state bonus and contributions from your employer, if you have one. This might enable pensions to retain some attractions for the self-employed.
The big question ultimately is how these two beasts, the Lifetime ISA and the pension, will co-exist. Given the undoubted value of employer contributions, many experts will continue to argue strongly for the merits of pension saving, probably alongside a Lifetime ISA. Equally, since the government will stop providing top-ups for the Lifetime ISA once the holder reaches the age of 50, it would make sense for people to step up their pension saving from that age (or to start a pension if they don’t already have one) in order to continue receiving a subsidy from the state. Osborne also made clear that the ability to take 25 per cent of a pension fund tax-free is not going to be abolished, further bolstering the case for pensions in the more competitive market they will face.
Ultimately, it looks like the Lifetime ISA could have quite an impact. There are caveats, however. If Lifetime ISA holders want to access their money early for reasons other than to buy a property, they will have to pay back the top-up bonus on the sum they withdraw, plus any interest or capital growth that has accrued, plus a 5 per cent levy. This amounts to a strong incentive not to dip in for any old reason and could well catch out the unwary who heed only the marketing messages about flexibility and choice.
The other big question is how the money that goes into Lifetime ISAs will be saved or invested. If people simply pile up cash they will earn very meagre returns over long periods—their money certainly won’t grow as fast as house prices are currently rising, for example. But it will also be difficult to work out what Lifetime ISA money should be invested in, if not cash, because of the possibility that people will decide to withdraw the money early to fund a property purchase. In this case, they could end up having to sell out of the stock market at a bad moment because they need the money. Working out how to provide capital growth, while protecting Lifetime ISA holders from the worst downsides of a badly-timed sale, will be difficult.
Much is still to be resolved, but one thing is clear: George Osborne has started another, slow-burning revolution in the world of pensions.