Economic View: Don't waste the tax breaks

What was a background worry has leapt right to the front: the implications for pension funds of the plunge in equity markets.

What was a background worry has leapt right to the front: the implications for pension funds of the plunge in equity markets.

Of course, pension planning is a long-term business and anyone who has been caught by the recent collapse has been both unlucky and ill-advised. The normal pattern of funded pensions is for an increasing proportion of the fund to be switched from equities to fixed-interest as the person approaches retirement, to protect against exactly the sort of share market crash that has happened. But from a macro-economic point of view, what has been happening is disturbing because it is undermining the whole principle of funded pensions.

The background arithmetic of an ageing population and longer life expectancy is generally known, though the projected ratios of the size of the workforce relative to the number of retired folk still come as something of a shock. Do you know that both Italy and Spain will have fewer workers than pensioners in 2050? Or that our present ratio of well over three workers to each pensioner will have shrunk to fewer than two? That the UK has somewhat more favourable demographics than continental countries (see left-hand graph above) might seem mildly encouraging were it not for the fact that being better than the others merely means having a big problem instead of an impossible one.

Why should we worry about 2050? Well, this is when people who are joining the workforce now will be drawing their pensions. And in some countries there will be a problem much sooner, as you can see on the 2015 projections.

This arithmetic has particularly dire implications for countries that rely on unfunded state pensions, where each gener- ation of working people has to pay the previous generation's pensions. You can see some of the projected public deficits in the next graph. Now that cannot happen. You cannot have debts of several times GDP, so the schemes will have to be curtailed. In the case of the UK, which does not have a large potential deficit, the projected pensions are tied to prices rather than earnings – an assumption that has to be modified now Gordon Brown has started to boost state pensions. So we do have a public pension problem too. Those projections, done before our Chancellor modi- fied the approach, are already too favourable.

It is this inexorable arithmetic that will push governments to try to persuade more and more people to make their own provision for retirement. The tragedy is that just at the time when people should be nudged in this direction, the UK Govern- ment has imposed double taxation on dividends on pension funds – or rather ended the relief that they had always had. The scale of that error, in Mr Brown's first Budget, is only now becoming clear. Eventually that decision will be reversed – it has to be – but that may not be for several years.

So while on paper the UK has a relatively strong private pension pool (see third graph), it is not nearly strong enough. The figures there were calculated before the latest market crash, so already the ratios to GDP will be much less favourable than they appear.

That leads on to several further problems. One is simply that the fall in the markets may encourage people to save less rather than more. There is not much to be done about this, except to point out that anyone saving for a liability 30 or more years hence is bound to have periods when the value of their investments falls. But people need assurance.

Another problem is the need for institutional holders to maintain various legal ratios, which has meant that many have had to unload their more marketable shares at miserable prices just to stay legal. The scale of this has been huge – estimates of £25bn of shares sold and upwards – and at last the Financial Services Authority is changing the rules to try to stop them having to do so.

There have been other wounds inflicted by the authorities. If people want to set money aside in a pension fund, they can do so with tax advantages. But if they want to invest some money in a house and then let it out, they cannot. So investment in certain assets is penalised while in others it is favoured.

Now all this might not have mattered in a bull market. Or to put the point slightly differently, in a bull market it was possible to get away with tax distortions because returns on equities were so high and the capital gains so large that they could offset tax and regulatory handicaps. But that matters like anything now.

So what's to be done? Well, the Government has produced a set of plans that will fiddle with the tax incentives but won't really cut to the heart of the problem.

And this is that any incentives which are really going to have a radical impact on our willingness to save will favour those with money. Rich people can save more than poor people. Faced with this, you can do one of two things. One is to follow the course taken by this Government and try to retarget incentives. The other would be to say, look, we need more savings. The more we can get people to save for themselves, the more public money will be available for those who can't afford to do so. Let's not worry so much about leakage, because the really rich will be able to find loopholes anyway. Instead, let's simplify the whole savings market so that, provided savings are locked away until a reasonable retirement age, they will carry lower levels of tax. How much people save (within reasonable limits) and what they do with it is their business, not the state's.

This is the way US legislation is going. We will do the same eventually. But better to make a start now. It has been a scary time for people approaching retirement, and helping them offset the market crash would have social as well as economic benefits.