The Mother of All Battles

For many, it is not an issue that rushes the ideological blood but the looming battle over mandatory pensions could well determine the future direction of the welfare state.

The issue arises because the current system is unsustainable, unjustifiable and, in many instances, just plain obscene. While the highest payment level under the state pension system hovers around the relative poverty line, taxpayers pay out more on regressive private pensions which primarily benefit the wealthiest in society.

According to the respective Statistical Reports of the Revenue Commissioners and the Department of Social Affairs:

• We spent, in 2003, about €2.5 billion on all state social welfare pensions.
• However, in that same year, it cost €2.9 billion to subsidise private pensions (the combined cost of employees and employers contributions, net pension fund income exemption and Retirement Annuity Premiums). And this excludes the tax subsidy to lump sum retirement payments for which Revenue can’t estimate.

Who benefits from this massive private pension subsidy? According the Gerry Hughes, in For Richer For Poorer (an essential text on the current pension system) approximately 75% of the tax relief subsidy goes to the top 20% income earners. Simply put, those who can’t afford to save are forced to subsidise those who can.

This regressive system has resulted in one of the highest levels of pensioner poverty in Europe, the lowest level of replacement income for pensioners (i.e. pension payments as a % of average incomes) and low levels of pension coverage; Ireland is one of the few industrialised countries in the world not to have a 2nd mandatory pension system. And it shows.

Even so, this sorry state has its supporters. The private pension lobby (though calling it ‘private’ is a gross misnomer as it exists only because of massive taxpayer subsidy) is adamantly opposed to mandatory pensions, mostly out of fear of losing access to savings. Employers, at least those who don’t already operate legitimate occupational pensions, are opposed because of the inevitable rise in payroll in taxes.

Still, there is a growing acceptance that something needs to be done. The State pensions system currently acts as a ‘poverty-avoidance’ payment; that is, it provides a flat-rate payment that keeps people at about the relative poverty line. What it doesn’t do is provide an adequate replacement income in old age. For those on average incomes (e.g. €40,000), the State pension makes up only 27% of their gross salary.

To top up people either need to be a member of an occupational scheme or rely on their own savings with tax relief support. There are two problems here: occupational schemes in the private sector are vanishing at an alarming rate and many others are being downgraded from final salary schemes (whereby employees are guaranteed a % of their final salary) to contribution schemes whereby employees receive benefits solely dependent on the value of the contributions that have been paid to the scheme and the investment return earned on those (the National Pension Board has been especially critical of contribution schemes, claiming they are inadequately funded).

A second problem is the cost of savings. For someone outside an occupational scheme – the majority of private sector employees – regular savings of up to 12% per year of gross income for 30 years, would be needed to provide an adequate post-retirement income (e.g. 66% of final salary). This is just too expensive for people with mortgages, families, childcare and medical costs, etc. Something has to give and its usually savings for old age.

And here’s the cruelest of catches – even if you did save for 30 years, the current system cannot guarantee you a defined pension. It all depends on the markets – retire when Asian or American or equity markets are in a slump, and you’ll get a lot less than you counted on. For many, it’s a lot of money for a shot in the dark.

There is a way out of this regressive and costly trap. A State Earnings-Related Pension (SERP) could ensure economic security in old age at a much-reduced cost for people and the State. Here’s how it would work:

• All income – including capital gains, gifts, inheritances, etc. - above a certain threshold (e.g. €15,000 per year) would be subject to a levy of approximately 12% to be split evenly between employees, employers and the State – 4% each.
• At retirement, people would receive 66% of their final salaries (whether the final year or an average of the preceding five years).
• To help fund this programme, tax relief on private pensions would be massively curtailed. For instance, tax relief would be standard rated, while the amount of contributions receiving relief would be capped.

Such a programme would amount to a revolution in people’s life-expectations. Instead of worrying over old age – shopping around different investment schemes which few people understand or buying second properties as a retirement nest egg – people would pay over a small levy to the state and, in return, know that they would be economically secure.

Of course, there are a number of other difficult issues that would have to be confronted – retirement age, tax treatment of pensioners’ incomes, reform of current welfare programmes such as free travel, etc. But the adoption of a SERP scheme would make such reforms easier to introduce since it would be part of a larger package of providing security and income adequacy to pensioners.

Unfortunately, this most important issue will receive little attention in the election manifestos. Fianna Fail knows something has to be done but won’t say anything until after the election. The PDs and Fine Gael are, of course, opposed to mandatory pensions while it is difficult to make out the Labour position.  For all political parties, cowardice will out and the issue will not feature.

But for progressives this should become an important battleground. We must move the debate about the welfare state away from ‘poverty-avoidance’ and towards the terrain of economic security. Providing people with financial stability and adequacy – especially in a more dynamic and volatile economy – will be an important barometer of the political will to introduce a modern welfare state.

And pensions will be the first battle.

Comments

[Lorenzo]

Tax relief on pension contributions only defers taxation, it doesn't avoid it altogether. So the cost of private pension subsidies should take account of taxes on pensioner's income.

Thanks for the link by the way.

[Michael]

That is true but only up to a point. For instance, 25% of a pension pot can be drawn down tax-free. Therefore, someone with accumulated tax-supported savings of €1 million can take €250,000 tax-free.

Further, while pension income is taxed, a substantial portion is, of course, below the tax-free threshold, while significant sums are taxed at the standard rate even though the savings attracted the top tax rate break. There are also tax-free implications for PRSI levies.

Nonetheless, you raise an important point and information on the inter-action of pensions, tax and tax relief is limited. The Revenue Commissioners can only estimate the cost based on extrapolations of data. A full survey of this data would bring greater clarity to the debate.

[Niall]

To further develop Michael's point, additional tax relief is also granted to those aged over 65 by way of much higher increased exemption limits for those over that age.

In effect, a person could draw down 5% of the fund without suffering any tax. The exemption limit for a married couple for 2007 is €38,000.

If deferral was the issue, then there would be no problem. However, it would also make no sense to defer tax. At the least there is the aim to get relief at the higher rate, but pay tax at the lower rate.

There is also the issue of PRSI. Relief is given against both employee and employer Prsi.

Finally, the main reason for building up excessive pension funds,tends to be the avoidance of CAT.

Under McCreevey amendments, the balance at death is not taxable as income at death and then the net amount liable to CAT. Instead the balance is taxable at a flat rate of 20%.

The difference is huge. Assume a net amount left at death of €2,500,000. The income tax due would have been €1,025,000 and a further CAT charge of €295,000, leaving a net amount for distribution of €1,180,000. Instead, there is just a flat rate of €500,000 payable, a saving of €720,000.

Before there was a ceiling placed on these funds, it was reported that there were 2 'pension' funds with assets in excess of €100M. The saving for each of these funds is approx. €30M!

[Lorenzo]

Some valid and interesting points. I agree not all tax is deferred, some is avoided altogether by the combination of 'income smoothing' and greater tax reliefs for the over 65s.

I don't know if the figures are available from the RC but if it is accepted that any (or at least most?) of the income tax paid by retirees has come from their pension funds, then this figure should be deducted from the original 'cost of private pensions' as calculated by Michael.

I haven't done the calculations but I'm pretty sure saving 12% of income above €15K won't come within an asses roar of funding a pension of two thirds of final salary.

I should disclose that I am currently working for an international investment management company but only as a lowly techie on contract. Also they don't sell in Ireland, so I have no particular (work) axe to grind.