Current pension tax reliefs inequitable and unsustainable

Gerard Hughes19/08/2009

Gerard Hughes: Reading Paul O’Faherty’s opinion piece in the Irish Times on 29 July one would not suspect that it is the private pension system rather than the State pension system which is in crisis.

In 2008 Irish pension funds lost €27 billion as the value of the average managed fund fell by almost 35 per cent. This was the greatest relative loss in value of 37 OECD and non-OECD countries. The loss of over one-third in pension assets resulted in an estimate by the Minister for Social and Family Affairs that up to 90 per cent of defined benefit schemes were underfunded at the end of 2008. Rubicon Investment Consulting estimates that returns on group managed pension funds in the ten years up to the end of 2008 amounted to 0.2 per cent per annum on average, or well below the annual rate of inflation of 3.7 per cent. This is an abysmal performance. Contributors to pension funds would have been better off if they had put their money in the Post Office.

Recent pension surveys indicate that up to half of all defined benefit schemes are closed to new members and that over 40 per cent of firms which have defined benefit schemes are considering reducing member benefits. Some employers and employees are considering reducing their contributions to defined contribution schemes even though the government’s Green Paper on Pensions points out that the average contribution to these schemes is too low to provide an adequate income in retirement. There is a long-term change from defined benefit to defined contribution schemes which is shifting the risk of poor pension returns from employers to employees.

None of these weaknesses of the private pension system are mentioned by O’Faherty. Instead he argues that pension tax relief, which cost €3.2 billion in 2006, amounts only to tax deferral because the tax forgone will be recovered during retirement when pensions are paid. His argument ignores the more favourable tax exemption limit for people aged over 65, the fact that up to ¼ of the value of the pension is taken as a tax free lump sum, and that a great many taxpayers who pay tax at the higher rate during their working life only pay tax at the standard rate when they retire. In its country report on Ireland in 2008 the OECD concluded that the overall effect of our favourable tax arrangements for pensions “ … is in effect fairly close to being … [a] system where income channelled through pensions is unlikely to be taxed at any point of the life-cycle.” An earlier report in 2004 by OECD researchers Yoo and de Serres showed that the tax deferral argument of the pensions industry is wrong as the long-term budgetary cost of pension tax reliefs in Ireland, on a present value basis, amounted to nearly 2 per cent of GDP.

O’Faherty argues that tax relief for private pensions should not be curtailed because private pension provision “offers the only prospect of alleviating the burden [of an ageing population] on the State.” The evidence which is available from a study by Hughes and Watson for the ESRI of the performance of the State and private pension systems shows that the private pension system does a very poor job of delivering pensions except for higher income earners. Over 90 per cent of pensioners receive an income from the State compared with about one-third who receive an income from a private pension. The State pension is also by far the most important source of income for 80 per cent of pensioners. The top 20 per cent of pensioners is the only group for which the private pension system provides a significant share of their retirement income. This is hardly surprising as around two-thirds of the tax relief on employee and self-employed pension contributions accrues to higher rate taxpayers.

The inequitable distribution of the tax relief for pensions, the low level of the State pension and the challenge of providing adequate pensions for an ageing population are the main reasons why the TCD Pension Policy Research Group, TASC and others have argued that the tax relief for pensions should be given at the standard rate of tax and that the revenue which would become available should be used to increase the State pension above the poverty level. As an ESRI study by Callan, Nolan and Walsh showed in 2008, this policy would eliminate the risk of poverty for people who are already retired. If it were adopted it would provide protection against poverty in retirement for the increasing number of people in the future who are likely to receive lower private pensions relative to pre-retirement earnings than current pensioners and it would contribute to a sustainable basis on which to pay for State pensions as the population ages.
Gerard Hughes is a Visiting Professor in the School of Business Trinity College Dublin and a member of the TCD Pension Policy Research Group

Posted in: WelfareTaxation

Tagged with: pensionstaxation

Prof Gerard Hughes

Hughes, Gerard

Gerard Hughes is an economist specialising in labour market issues relating to pensions, employment and migration. He worked at the ESRI where he was a Research Professor. A founding member of the European Network for Research on Supplementary Pensions and of the Pension Policy Research Group in Ireland, Gerard has published a number of reports on the coverage of pension plans, tax expenditure on pensions and pensioners’ incomes, as well as reports for the OECD and the ILO on private pensions in Ireland. He has contributed to and co-edited a number of books on pensions including Reforming Pensions in Europe and Personal Provision of Retirement Income.



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