Chapter 1. Why countries provide tax and non-tax financial incentives for retirement savings

This chapter first explains the scope of the analysis, describing the different types of financial incentive considered, it then presents different motives for countries to introduce financial incentives to promote savings for retirement, and it ends providing the structure of the publication.

    

1.1. Scope of the analysis: Tax and non-tax financial incentives

The analysis in this publication covers two types of financial incentive that countries use to encourage individuals to save for retirement in funded private pension plans: tax incentives and non-tax incentives.

Tax incentives come from a differential tax treatment applied to funded pension arrangements as compared to other savings vehicles. In most countries, the “Taxed-Taxed-Exempt” (“TTE”) tax regime applies to traditional forms of savings, with contributions paid from after-tax earnings, the investment income generated by those savings taxed and withdrawals exempt from taxation. When the tax regime applied to funded pension arrangements deviates from the “TTE” tax regime, this could lead individuals to pay less taxes over their lifetime.

Non-tax financial incentives are payments made by the government directly into the pension account of eligible individuals. They can take the form of matching contributions or fixed nominal subsidies. Matching contributions are usually conditional on the individual contributing and correspond to a certain proportion of the individual’s contributions, up to a nominal ceiling. Fixed nominal subsidies are designed to attract low-income earners as the fixed amount represents a higher share of their income.

Other types of financial incentive exist but are not considered. These include non-tax incentives provided on social contributions (e.g. deduction of pension contributions for the calculation of social contributions, reduced social contribution rate on pension withdrawals) and tax incentives provided to employers (e.g. tax allowances when making contributions on behalf of certain employees).1 Employers may also match employees’ contributions. These types of financial incentive are included in the country profiles in Annex A but are not further considered in the analysis.

1.2. Why countries provide financial incentives for retirement savings

Policy makers, when introducing financial incentives for funded pension arrangements, may aim at increasing overall savings, reallocating savings into retirement savings plans, developing the supplementary role of funded pensions in the provision of retirement income, or simply at treating equally all types of retirement savings, whether in public or private schemes.

Some countries have low national savings relative to their investment needs and may wish to increase overall savings. The level of national savings has important implications for the economy, as it provides a source of funds available for domestic investment, which in turn is a key driver of labour productivity and thus higher future living standards. Increasing national savings could be achieved by introducing incentives to encourage new savings (i.e. through a reduction of consumption or an increase in labour supply). These incentives could focus on retirement savings plans.

Retirement savings are for the long haul. Therefore, increasing savings for retirement could increase long-term investment, enhance the depth and characteristics of the financial sector and facilitate long-term growth. Thus, even a country that has enough overall savings may want to promote funded private pensions to reallocate savings into retirement savings plans. In addition, even if people know that saving for retirement is for their own best interest, they do attach more weight to present than to future consumption and therefore tend to save too little. In that respect, procrastination, inertia and short-sightedness can be significant barriers to act. Reallocating other types of savings into retirement plans would not increase overall national savings (combined public and private) but would earmark a greater share for retirement. However, money in retirement savings plans is usually locked in until retirement, while other savings vehicles usually offer more flexibility as to when and how to make use of the money. Financial incentives therefore need to account for this constraint.

Recent reforms to pay-as-you-go (PAYG) financed public pension systems have increased the need to enhance the role of private pensions in the provision of retirement income. OECD governments have been active in reforming pension systems over the last decade (OECD, 2017[1]), often readjusting downwards public pension benefits to make them financially sustainable and increasing the role of private pensions, in particular defined contribution plans. Providing financial incentives is intended to increase participation in, and contributions to, retirement savings plans in order to complement public provision, increase overall pensions and thus improve pension adequacy. In addition, promoting retirement savings is a way to help people accumulate enough financial resources by the time they retire, thus reducing reliance on the public safety net which helps to rein in public expenditures.

Finally, public PAYG pension arrangements are generally subject to the “EET” tax regime. In most OECD countries, employees’ social security contributions are deductible from income, the (implicit or explicit) internal rate of return of the PAYG scheme is exempt from personal income tax, and pension benefits are taxed as income (OECD, 2017[2]). Countries may want to treat savings, whether through PAYG or funded pension arrangements, equally, in particular when these are part of the mandatory system.

1.3. Structure of the monograph

The purpose of this monograph is to review how countries design financial incentives to promote savings for retirement and examine whether there is room for improvement. Given that financial incentives entail a fiscal cost to governments, it is important to verify whether they are effective tools for encouraging people to save for retirement, taking into account different needs across different population subgroups.

The monograph first describes how countries currently design financial incentives. It then assesses the overall tax advantages that these incentives provide to individuals, how these incentives affect the way individuals save for retirement and the fiscal cost these incentives entail to governments. The monograph also compares different approaches to designing financial incentives based on their inherent characteristics and using a common framework to assess the different implications for individuals and governments. Finally, it provides policy guidelines to help countries improve the design of their financial incentives with a view to promoting savings for retirement.

The monograph is organised as follows. Chapter 2 describes the tax treatment of retirement savings in funded private pension arrangements across 42 OECD and selected non-OECD countries.2 It provides details regarding the tax treatment of contributions, returns on investment, funds accumulated and withdrawals. It also describes non-tax financial incentives offered to individuals saving for retirement, mainly matching contributions and fixed nominal subsidies.

Chapter 3 assesses the extent to which different designs of tax and non-tax incentives translate into a tax advantage when people save for retirement. This assessment requires a common metric to compare the outcome of the different tax and non-tax incentives across countries. The analysis uses the overall tax advantage as the metric. The approach used consists in comparing the tax treatment of a private pension plan to that of a benchmark savings vehicle, i.e. comparing how contributions, returns on investment and withdrawals are taxed in each savings vehicle. The overall tax advantage is then defined as the amount that an individual would save in taxes paid during their working and retirement years by contributing the same pre-tax amount to a private pension plan instead of to a benchmark savings vehicle. Chapter 3 first introduces the overall tax advantage and describes how the metric varies with different parameters. It then calculates the overall tax advantage provided in OECD and selected non-OECD countries when people save for retirement.

Chapter 4 then examines whether financial incentives are effective tools to promote savings for retirement. It reviews the empirical and non-empirical literature analysing how tax and non-tax financial incentives affect the way individuals save for retirement. In particular, it assesses whether individuals increase their participation in, and contributions to, retirement savings plans as a response to financial incentives, and whether this is achieved through an increase in savings or a reallocation of savings.

Financial incentives to promote savings for retirement entail a fiscal cost to governments. Chapter 5 therefore assesses the cost of promoting savings for retirement via tax and non-tax financial incentives from the point of view of fiscal policy and the budget. It first defines the concept of tax expenditure and presents how countries report the cost related to financial incentives for retirement savings. It then introduces the net tax expenditure measure to be able to have cross-country comparisons, and calculates that measure for a selection of countries over the period 2015-2060. The analysis and calculation of the net tax expenditure is done for countries that have the appropriate data to be able to make those calculations (e.g. having the breakdown by age in 2015 of the number of contributors, total contributions, total assets, the number of beneficiaries and total withdrawals).

Chapter 6 assesses alternative approaches to designing financial incentives to promote savings for retirement. The purpose is to see whether there are other approaches that would provide an improvement on the current main approach to providing incentives that taxes only withdrawals and exempts contributions and returns on investment. The analysis measures improvements both through the tax advantage that people may get over their lifetime when saving for retirement, and through the fiscal cost for the treasury. It uses a theoretical framework and illustrative cases to conduct such comparison, abstracting from country-specific parameters, to understand the inherent characteristics and implications of different approaches.

Chapter 7 ends by proposing a set of policy guidelines to help countries improve the design of their financial incentives with a view to promoting savings for retirement. These guidelines are based on the analysis of country practices and on the comparison of the inherent characteristics of different approaches to designing financial incentives to promote savings for retirement.

The annex provides country profiles with detailed information about how OECD and selected non-OECD countries design financial incentives to promote savings for retirement. Each country profile describes: i) the structure of the funded private pension system; ii) the tax treatment of retirement savings (contributions, returns on investment, funds accumulated and withdrawals); iii) non-tax incentives; iv) the social treatment of contributions and benefits; v) the tax treatment of pensioners; and vi) the incentives for employers.

References

[1] OECD (2017), Pensions at a Glance 2017: OECD and G20 Indicators, OECD Publishing, Paris, https://doi.org/10.1787/pension_glance-2017-en.

[2] OECD (2017), Taxing Wages 2017, OECD Publishing, Paris, http://dx.doi.org/10.1787/tax_wages-2017-en.

Notes

← 1. Social contributions are usually levied on gross salaries and wages to finance among others, health care insurance, unemployment insurance, public pensions and disability pensions

← 2. The selected non-OECD countries are the non-OECD EU Member States plus Colombia, which is in the process of joining the OECD.

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