Are tax incentives the best way to encourage people to save for retirement? This publication assesses whether countries can improve the design of financial incentives to promote savings for retirement. After describing how different countries design financial incentives to promote savings for retirement in funded pensions, the study calculates the overall tax advantage that individuals may benefit from as a result of those incentives when saving for retirement. It then examines the fiscal cost of those incentives and their effectiveness in increasing retirement savings, and looks into alternative approaches to designing financial incentives. The study ends with policy guidelines on how to improve the design of financial incentives to promote savings for retirement, highlighting that depending on the policy objective certain designs of tax incentives or non-tax incentives may be more appropriate.
Financial Incentives and Retirement Savings
Abstract
Executive Summary
Governments have long used financial incentives to promote savings for retirement. Financial incentives are meant to encourage participation in retirement savings plans and boost overall retirement income by making private savings, as a complement to public savings, more attractive. Historically, tax incentives have been the dominant type of incentive, providing favourable tax treatment to retirement savings as compared to other types of savings. More recently, new types of financial incentives have emerged, which are not linked to the tax system. These non-tax incentives include matching contributions, where governments match the employee’s contribution to the pension account, and fixed nominal subsidies paid into the pension account of eligible individuals.
This publication reviews how countries design financial incentives to promote savings for retirement and considers whether there is room for improvement. Given the cost that financial incentives represent to governments, it is important to verify whether they are still effective tools to promote savings for retirement, taking into account different needs across the population. The publication ends with policy guidelines to help countries improve the design of their financial incentives for promoting savings for retirement.
Key findings
All countries provide financial incentives to promote savings for retirement. The most common approach exempts contributions and returns on investment from taxation and taxes withdrawals (“EET”).
In all countries, financial incentives provide an overall tax advantage to individuals, in the sense that they pay less taxes over their working and retirement years when contributing the same amount (before tax) to a retirement savings plan rather than to a benchmark savings vehicle. This overall tax advantage varies with the income level of the individual.
Financial incentives, tax and non-tax, can be effective tools to promote savings for retirement. In particular, allowing individuals to deduct pension contributions from taxable income encourages participation in and contributions to retirement savings plans for middle-to-high income earners, because individuals respond to the upfront tax relief on contributions that reduces their current tax liability. Low-income earners are more sensitive to non-tax incentives (matching contributions and fixed nominal subsidies) than to tax incentives.
The total fiscal cost of financial incentives varies greatly across countries, but remains in the low single digits of GDP. Its evolution over time depends on the extent to which retirees draw their pension based on a full career and constant contribution rules and the countries’ demographics.
The way individuals perceive different designs of financial incentives may distort plan choices and savings levels even though those designs may be economically equivalent under certain assumptions. Low levels of financial knowledge and behavioural biases may lead some individuals to fail to choose the tax treatment that will provide them with the largest overall tax advantage.
Policy guidelines
1. Financial incentives are useful tools to promote savings for retirement. They encourage people to participate in and contribute to retirement savings plans, while keeping individual choice and responsibility for retirement planning.
2. Tax rules should be straightforward, stable and common to all retirement savings plans in the country. Different tax rules for different types of plan and frequent changes to those rules may create confusion and reduce people’s trust in the system.
3. The design of tax and non-tax incentives for retirement savings should at least make all income groups neutral between consuming and saving. This tax neutrality is achieved when the way present and future consumption is taxed makes the individual indifferent between consuming and saving. The tax treatment of retirement savings should at least not discourage savings.
4. Countries with an “EET” tax regime already in place should maintain the structure of deferred taxation. The upfront cost incurred at the introduction of the pension system with deferred taxation is already behind in most countries and the rewards in the form of large tax collections on pension income are in the horizon.
5. Countries should consider the fiscal space and demographic trends before introducing a new retirement savings system with financial incentives. The maturity of the pension system and demographics influence the fiscal cost related to financial incentives.
6. Identifying the retirement savings needs and capabilities of different population groups could help countries to improve the design of financial incentives.
a. Tax credits, fixed-rate tax deductions or matching contributions may be used when the aim is to provide an equivalent tax advantage across income groups. Financial incentives that equalise the tax relief provided on contributions for all individuals, independently of their income level and marginal income tax rate, achieve a smoother distribution of the overall tax advantage across the income scale.
b. Non-tax incentives, in particular fixed nominal subsidies, may be used when low-income earners save too little compared to their savings needs. Non-tax incentives are better tools to encourage retirement savings among low-income earners, who are less sensitive to tax incentives.
7. Countries using tax credits may consider making them refundable and converting them into non-tax incentives. Individuals with a low tax liability can still benefit from tax credits when they are refundable. The value of the credit is strengthened when it is paid directly into the pension account, in order to help individuals to build larger pots to finance retirement.
8. Countries where pension benefits and withdrawals are tax exempt may consider restricting the choice of the post-retirement product when granting financial incentives. When withdrawals are tax exempt, financial incentives may lose their purpose if individuals withdraw early or take a lump sum. To counter this, policy makers could restrict the choice of when and how to withdraw the money; take back part or all of the financial incentives when individuals take a lump sum or withdraw early; or encourage people to selected post-retirement products that are more in line with the objective of people having a retirement income.
9. Countries need to regularly update tax-deductibility ceilings and the value of non-tax incentives to maintain the attractiveness of saving for retirement. Keeping tax-deductibility ceilings for contributions and the value of non-tax incentives (maximum matching contribution, subsidy) constant over time may reduce the attractiveness of saving for retirement and lower the positive impact on participation and contribution levels.w
