DIY investor: Give a child a pension

Around five years ago, I gave each of our children about the last thing anyone would put on their Christmas list: a self-invested personal pension. My rationale was simple: investment gains are a product of time and money, and the more of one you have the less of the other you’re likely to need. Children have an abundance of time and no money, so I reasoned that investing even fairly small sums over 60 years or more would make the most of the biggest advantage they enjoy: their youth.

At least, that’s how I rationalised it. Looking back, however, I have to admit the deciding factor was far less esoteric—it was the lure of free money.

For children, tax relief on pension contributions is an excellent deal. Up to £2,880 a year can go in for each child and attract tax relief at 20 per cent, lifting the total to £3,600. Since children pay no tax, it felt as though we were somehow beating the system. Or to put it another way, the incentive to save for a long-distant future that the tax relief was intended to provide had worked a treat in my case. If this incentive hadn’t been available, I doubt I would have set up their Sipps (self-invested personal pension), even though I fully understood the benefits they stood to gain by entering adulthood with the basis of their pension fund already in place.

This issue of incentives came to mind again with the public consultation, announced in George Osborne’s July Budget, on the future of pension tax relief. Much of the commentary that has accompanied this exercise (which closes at the end of September), has suggested that three main options are on the table: no change; a switch from tax relief at the individual’s highest marginal rate (20, 40 or 45 per cent) to a flat rate, perhaps 20 per cent; or the introduction of an Individual Savings Account-type system with a much smaller government top-up when money goes in but no tax to pay when it is finally taken out.

Not surprisingly, most attention focused on the radical “Pension Isa” option. My heart sank: is there no end to the permanent revolution that has engulfed Britain’s pension system? How could this idea possibly make matters any less chaotic and confusing than they already are, given that we would have to run the old system and the new alongside each other for the next 50-plus years? Do we really think people will be persuaded to put off spending and save significant sums for the distant future if the immediate tax incentive shrinks dramatically? My own experience suggests not.

Why then is the government even considering it? A big part of the reason is pension tax relief is not only expensive—around £34.3bn in 2013/14, according to the consultation paper—but the benefits flow overwhelmingly to the better off. Around two thirds of that £34.3bn went to 40 and 45 per cent taxpayers.

So some change looks inevitable; but what and how much? The pensions industry is against the Isa idea and it’s easy to see why. Tax relief is a powerful incentive to individuals to save but in its current form it also adds nearly £35bn a year to the pension industry’s assets under management. If fund managers charge 1 per cent a year to invest that money, tax relief brings them additional annual revenues of getting on for £350m. No wonder they’re not keen on radical ideas. That’s why the government has allowed the Isa hare to run. What better way to persuade the pensions industry to support the abolition of tax relief at 40 and 45 per cent (saving the government up to £12bn a year) than to offer an alternative that’s even worse? In the world of pensions, incentives still have a big role to play.