Lifetime ISA - a Trojan horse in the Wild West

Trojan horse?

Some have described the Lifetime ISA as a Trojan horse. That might not be the right metaphor. The Trojans might not have realised what that huge horse was, but it’s perfectly clear what the Lifetime ISA is – the beginning of the end of conventional ‘Exempt, Exempt, Taxed’ pensions.

The Lifetime ISA is proposed to be offered to 18-40 year olds, such that if they contribute up to £4,000 a year, the government will pay a 25% ‘bonus’ of up to £1,000. That tax break is exactly the same as an individual saving into a personal pension – just that what’s known as ‘20% tax relief’ in pensions is being spun as a ‘25% government bonus’ in Lifetime ISA.

But unlike pensions, instead of being locked away until age 55, the Lifetime ISA can be accessed, tax free, to fund a first home purchase, and can even be cashed in early, subject to a 25% charge (the government bonus and an extra 5% penalty). If used for retirement, the whole fund is available, tax-free, from age 60.

That accessibility has the potential to address the lack of people’s engagement with pensions. It’s hard to feel involved with a sum of money you can’t touch for several decades and no amount of communication is going to solve that. But the very fact that the Lifetime ISA can be accessed at any time may help people feel better connected to their savings.

That all sounds very appealing, to the extent that you have to wonder why this shiny new toy is only to be available to under 40s. And when you run through the numbers, it looks even better.

Let’s look at the case of a basic rate taxpaying under 40 year old. We’ll assume they are earning £24,000 (slightly less than average earnings, but it makes the numbers round) and have been auto-enrolled. By 2019, minimum contributions for the plan will be 5% from the employee, and 3% from the employer. These contributions will apply to many millions of people.

If the individual is in a pension plan, every month they will contribute £80 net, which will be grossed up to £100 by the addition of 20% relief. Their employer will contribute £60, meaning that every month £160 is being invested. Let’s ignore charges and growth on that £160. At retirement, 25% of the fund is payable tax free (£40), while we’ll assume the other 75% is subject to 20% tax (making £96 net). So in total, the pension will produce a net output of £136 from an employee cost of £80.

But what if the individual instead directs everything towards a Lifetime ISA? The employee contribution is identical. If they save £80 from taxed earnings, that money will receive a £20 ‘government bonus’, meaning that £100 is invested, just as it would be in pensions.

And the employer’s contribution? Let’s suppose the employer is willing to pay the £60 to the individual who then pays to the Lifetime ISA. Assuming the employer wants to keep its costs to £60, employer NI at 13.8% would first need to be deducted, meaning that £52.72 would be payable to the individual. Then the employee would be subject to 20% tax and 12% NI, leaving them with £35.85. If they put that £35.85 into the Lifetime ISA, it too will qualify for the 25% government bonus, increasing it to £44.81.

Overall therefore, £144.81 is invested in the Lifetime ISA, less than the pension (purely because there is less upfront help from the taxman in the Lifetime ISA– both employer and employee have identical costs in both options). But this is an ISA, and so there is no tax on the money paid out at retirement after age 60 – meaning that this employee is better off under the Lifetime ISA.

So millions of people could potentially be better off in a Lifetime ISA, rather than a pension, purely for funding retirement and even before we look at the house purchase and ‘rainy day’ possibilities. I don’t pretend this is universally the case – the larger the employer contribution, the more attractive the pensions tax and NI framework.

This raises some serious questions. We have no choice but to auto-enrol people into pensions, but the Lifetime ISA might be a better option for huge numbers of people. Should we be pushing for formal auto-enrolment status for the Lifetime ISA?

If that were to happen, the Lifetime ISA might need greater infrastructure around it. The governance of DC pensions has been materially strengthened in just the past 4-5 years. Every auto-enrolment compliant plan has to have a default investment option. That default investment option must operate within a 0.75% charge cap.

For contract-based plans, we have the concept of Independent Governance committees. DC trustees are charged with assessing value for money and producing formal Chair’s statements. Looking back just a little further, we have the requirement for formal consultation when pension scheme designs change.

All of these measures have happened in the past decade or so and all have strengthened DC pension provision and member protection. But they have left pensions inhabiting some kind of unnavigable Kafkaesque world of rules, statutory instruments, Ombudsmen and Regulators,

By stark contrast, ISAs exist in a relative Wild West. Not a single one of the governance measures listed above applies to ISAs. There is no default investment option for an ISA (although cash has arguably emerged as such). There is no limit to charges. While pension plans have come to the realisation that too much choice can be too much, ISA supermarkets routinely offer access to hundreds of funds.

On the other hand, ISAs do not have a Lifetime Allowance, and their relative simplicity means no-one has yet deemed it necessary to set up and publicly fund an ISA Regulator, an ISA Ombudsman, nor an ISA Advisory Service.

Offered the choice between a Lifetime ISA and pension plan, what would you choose? What will employees want? For how long will we have a choice?