Government’s pension proposal would hit the ‘squeezed middle’

The Government has issued a consultation paper that contemplates reducing or replacing tax relief on pension contributions. It is hard not to conclude that this is seen by Government as a means to save on the impending cost of automatically enrolling workers in pensions.

Whilst the introduction of pension auto-enrolment is a very welcome and necessary step to broaden pension coverage and defuse Ireland’s pension time bomb, to accompany it with a cut in tax relief on pension contributions would be counter-productive.

Contrary to spin that suggests reduced pension tax relief would mainly affect the wealthy, the reality is that middle-income workers would be most impacted.

Three common misconceptions on this issue should be challenged.

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The first is that tax relief mainly benefits the very wealthy. This view is quickly dispelled once tax treatment after retirement is factored into the bigger picture.

If the Government imposes flat 20% tax relief for everyone it will have largely removed the incentive for middle-income earners to make additional contributions towards retirement

The very wealthy get higher-rate tax relief on their pension contributions while working. This may seem generous, but, importantly, they will also pay higher-rate tax along with Universal Social Charge (USC) on their marginal retirement income: this effectively balances out the tax relief originally received.

Contributions

Let’s contrast middle-income earners who pay higher-rate tax (kicking in at earnings above €34,550 per annum for a single person). Like the very wealthy they get higher-rate tax relief on pension contributions: a €100 contribution only costs them €60 in take-home pay. The difference arises in retirement, where middle-income workers usually drop to the standard rate of income tax or fall outside the tax net altogether. Since tax on their retirement income is lower than tax relief on their contributions they, unlike the very wealthy, currently benefit from a large net lifetime gain.

The second misconception is that income tax relief capped at 20 per cent would benefit everyone to an equal extent.

The short-term effect of flat 20 per cent tax relief on income would mean that a worker earning more than €34,550 per annum and contributing a fairly standard 5 per cent of salary per annum to their pension would effectively experience an immediate cut of around 1 per cent in their net pay.

In addition, they could face a scenario where marginal tax on their retirement income offsets the tax relief they got in the first place, with diligent savers facing tax in retirement that outweighs tax relief received on their marginal contributions.

Tax relief

Essentially, if the Government imposes flat 20 per cent tax relief for everyone it will have largely removed the incentive for middle-income earners to make additional contributions towards retirement, and it will have cut their net income if they are already contributing to a pension.

Does the Government really want the “squeezed middle” to be further squeezed in this way? How can this be consistent with the goal of getting more people to save for retirement?

A cut to Government support of pensions just as Government automatically enrols everyone in a pension is not sensible, necessary or fair

The third misconception is that a Special Saving Incentive Accounts (SSIAs) style top-up approach would be more popular and easier to understand.

People liked SSIAs not so much because of the mechanism used for the government subsidy but because they got their money back in five years with tax only applied to the gains.

Under a 1:3 top-up system (as mooted in the Government’s Pensions Roadmap) with the government contributing €1 for every €3 put into a pension pot by an individual, government support for the pension contributions of middle-income earners will have been cut. It’s wishful thinking to suppose this will not get noticed, and fantasy to suppose that it will be popular: any worker paying higher-rate tax and contributing 5 per cent of their salary to a pension would, as the first result of a 1:3 top-up system, experience an immediate drop of around 2 per cent in net pay as tax relief ceased.

Not sensible

A cut to Government support of pensions just as Government automatically enrols everyone in a pension is not sensible, necessary or fair. Cuts will create doubt and distrust exactly when the Government needs to unite society on the need for long-term saving. The UK managed to introduce auto-enrolment in the teeth of austerity in 2012 without removing higher rate tax relief.

The Government consultation on supplementary pensions reform, including the tax relief issue, has opened. Those representing the interests of middle-income workers should be engaging in the consultation and making their views known regarding the effect on take-home pay, on retirement wellbeing and on faith in pensions.

Danny Mansergh is head of member communications at Mercer