Money: Whitehall at war over our savings

It's the Brown v Harman tug-of-war, writes Clifford German. And your cash is the rope...

DOWN in Whitehall a battle is developing between the Treasury and the Department of Social Services to decide where we put our savings and investments.

The Treasury favours up-front savings and investments, largely because a high level of savings makes the management of consumption and funding of government borrowing easier, and it costs the Treasury nothing immediately in tax relief.

Even if the money is invested in Tessas and PEPs (and, from next year, Individual Savings Accounts) which are free of income tax on dividends and capital gains on profits, most of the tax revenue loss comes later, but the benefits to the Treasury are immediate. If, however, you put your money into pension plans the Treasury has to give immediate tax relief on your contributions and allow you to take 25 per cent of the value of your pension pot free of tax when you retire. Only then does it get a chance to tax pension income, often at a lower rate than you earned in your working life.

The DSS, on the other hand, wants you to put your money into pension plans because it will provide you with an income in old age and make it less likely you will become a burden on the state. Of course if you are rich enough when you retire - thanks to a lifetime of savings and investments - a pension does not much matter, but relatively few people attain that status.

Even fewer people will be able to afford both extensive savings and a substantial personal pension fund. In a perfect world everyone would have a portfolio of investments including cash accounts for short-term needs, long-term tax-free savings, PEPs and a pension plan. Life assurance and a mortgage may also be needed, and many may want health insurance and ways of financing private education for children. Few people can afford all that: for most people something has to give. The most obvious trade- off is between investments in equities and pensions.

Equities have grown in value faster than their nearest rivals, residential property, and the tax-free dividends on PEPs have almost kept pace with gross interest on building society accounts. The combined return on PEPs has exceeded most other investments, including residential property, Tessas and deposit accounts with banks and building societies - hence the controversy over the Government's plans to put a lifetime limit of pounds 50,000 on PEPs and end the tax-free status of excess holdings built up over the past decade.

In contrast, pensions have underperformed. Contributions to a pension fund still have the unique advantage that they come out of gross income, and the tax savings are significant, especially for top-rate taxpayers. But it is harder to monitor the performance of pensions funds: charges are on average rather higher than on PEPs, especially since the arrival of high-profile providers of low-cost tracker funds. And pensions have still not shaken off the bad name acquired as a result of the mis-selling of personal pension plans by over-enthusiastic salespersons in the late 1980s.

The decision to allow investors to retain all PEPs and maintain their tax privileges, and not to reduce opportunities to put money into ISAs when they take over from PEPs in April 1999, has alarmed social security ministers in charge of pensions policy. They fear that ISAs will mop up money the DSS would like to see go into pension provisions, and that the new generation of "stakeholder" pensions designed to appeal to investors who cannot afford existing personal pension plans will therefore flop.

But matters do not stop there. The investment management industry is equally worried that the new generation of pensions may actually divert money away from ISAs, especially from unit trusts and investment trust savings plans which do not have the ISA's tax benefits.

Although the ISA will be able to invest in a wider range of investments, including American, Far Eastern and emerging markets - something that PEPs could not do - the fact is from next year investors will only be able to tuck away pounds 5,000 a year into equities in an ISA against the pounds 9,000 a year allowed into PEPs.

But the biggest threat to ISAs and unit trusts may be compulsory pension contributions for everyone not entitled to an occupational or company pension scheme. Pension experts, such as Lyn Webb at Legal & General, say anyone wanting to retire on two-thirds paywill need to put an average 10 per cent of earnings into a pension fund over a working life, perhaps starting at 5 per cent and rising to 15 per cent in their last decade at work.

Putting money into a pension plan which they might not live to enjoy is not everyone's idea of a good way to spend money, and few members of existing personal pension schemes achieve the desired level of savings even with attractive tax relief. There is a real risk that poorer people on low incomes would find even an annual payment of 5 per cent into a pension fund a real financial burden unless the package was sweetened still further by employers being forced to match employees' contributions, or by further tax credits from the taxpayer, or by the imposition of a minimum wage.

This government is highly reluctant to take unpopular decisions, but the chances are that in order to get the desired level of investment into pension funds it will be forced to make pension contributions mandatory, with or without the other sweeteners.

If this happens, the chances are that many employees, forced to contribute to a pension plan for the first time, will be unable or unwilling to make payments into other savings plans, including ISAs. Pension plans, far from being crowded out, will make it difficult if not impossible to expand personal savings and investment plans as fast as the Treasury and investment managers would like.