Own a LISA? First impressions of the Lifetime ISA

In the build-up to the Budget, the Chancellor backed away from significant changes to the pension tax system for now, despite the strong case for some reform. This was a relief for some and a disappointment for others. But given that he had aimed to save money, it’s a surprise that he’s nonetheless introduced a new ‘Lifetime ISA’ (or LISA) for those under 40, in which savings are made out of after-tax income but receive 25p in government matching for each £1 saved – up to a maximum of £4,000 saved and a £1,000 public contribution.

Given the variety of savings schemes that are now available, individuals will be wondering whether the new scheme is a good investment for them. And politicians and taxpayers will be asking whether this is a good policy for the country.

For working households on Universal Credit, this clearly isn’t the best way to save. The separate Help to Save scheme is more generous, with 50 per cent matching on up to £600 of saving per year and with instant future access. And the welfare system gives Universal Credit recipients a very strong incentive to save into a pension, as this loss of disposable income is made up for by a 65p per £1 increase in support.

For those not on Universal Credit, LISA is more generous than other ISAs, giving as it does up to £1,000 a year in government matching. However, savings can only be used towards a deposit on a first home (extending the Help to Buy ISA) or locked up until the age of 60. Significantly, the government will be consulting on whether other life events should be cause for allowing permanent or temporary use of one’s savings, but for now dipping into LISA savings will lead to the loss of the matching (and any interest received on it) as well as a 5 per cent charge. For some this lack of flexibility will outweigh the financial benefit, but for young people saving for a house at least, using a LISA is a no-brainer.

More interesting is how LISA compares to pension saving, particularly for those who’ve already bought their own home. This is not entirely straightforward, given the combination of up-front tax relief, tax-free lump sum and taxation in retirement that exist for pensions. Whether this is better than the LISA scheme’s up-front taxation with 25 per cent matching depends on the tax rate that would be paid both now and in retirement.

For those who don’t pay tax in retirement (and currently these are actually the small majority) the current pension system is one of zero taxation at every stage. But the 20 per cent tax relief received by basic rate contributors (and by some non-taxpayers too) – which restores a net 80p to a 100p contribution – is equivalent to 25 per cent after-tax matching, with LISA therefore having the advantage over employee or self-employed pension contributions in terms of relative ease of access. (It remains to be seen whether money saved in a LISA will – like money saved through pensions – be ignored during working-age means-testing and whether it will – like pension income – count against pension credit in old age.)

For those paying the basic rate of tax both when saving and when in retirement (and no-one can know exactly what their marginal rate will be and how large the personal allowance will be in old age) £1 saved through LISA will be worth 18 per cent more in retirement than £1 saved through an extra pension contribution, after accounting for pension taxation. This doesn’t account for any employer contributions, but at the very least is important for the self-employed. The Budget states that, in addition to LISA being more flexible, “For the self-employed who pay the basic rate of tax it is at least as generous as a private pension, and more so if they expect to pay tax in retirement.”

But for higher rate savers, whose pension receipt is very unlikely to be primarily taxed at the higher rate, the benefit of current up-front pension tax relief is more generous than LISA’s 25 per cent matching. Saving £1 through LISA would leave the higher rate payer 12 per cent worse off than an employee or self-employed pension contribution made at the higher rate but received at the basic rate. Figure 1 shows the results for all likely combinations of contribution-stage and draw-down tax rates.

Were pension tax relief to be limited in the future, such as through a more progressive flat rate of relief, this pattern of incentives could change significantly.

Figure 1: Cash impact of using LISA versus employee or self-employed pension contributions, by tax rate now and in retirement

Source: RF analysis, for marginal saving ignoring employer pension contributions.

The picture is quite different once we consider employer pension contributions. With rapidly growing numbers of employees being auto-enrolled, opting out in order to redirect the minimum 5 per cent of eligible salary (from 2019-20) might mean losing their employer’s contributions (by then 3 per cent of salary), which would overwhelmingly cancel out any financial incentive to switch to other long-term saving vehicles. And due to National Insurance relief, employers’ own contributions will remain tax-favoured over personal LISA saving.

So for individuals there is a new investment option that in at least some cases will be the best form of saving and which might increase the incentive to save overall. But is it a good policy?

One concern is that by redirecting more saving towards schemes that can be accessed for buying one’s first home, this will inflate house prices. Indeed, the OBR have (with great uncertainty) added 0.3 per cent to their house price forecast for 2020-21 as a result of the policy. This is not just an increase in the cost of purchasing. Conversely it means existing homeowners have had their housing wealth boosted – by almost £900 in the case of the average house price. A first time buyer would need to contribute £3,500 to a LISA for the government matching to just make up for that higher average house price.

While it’s too early to fully assess the new policy, like any spending it should be judged on how it is targeted and on its cost-effectiveness. Where before the budget a reduction in the generosity of support for wealthy savers was expected, instead there has been more spending. And the (highly uncertain) £850 million per year cost of the policy by 2020-21 (together with a higher annual ISA savings limit) is notably higher than the £70 million expected to be spent on boosting Universal Credit recipients’ savings or the £115 million that the similar Saving Gateway would have cost (in 2014-15).

Unlike the current pension tax relief system, LISA’s 25 per cent matching doesn’t favour those on higher tax rates. But with a very high annual limit of £4,000 a year (double that for a couple), the maximum public contribution of £1,000 (£2,000 for a couple) will realistically be available only to those with the highest disposable incomes. Others may benefit simply by moving existing savings – or windfalls such as inheritance – into the new scheme to receive a 25 per cent wealth boost (though at the cost of reduced accessibility), but again it is only higher income households that tend to have high existing savings, as Figure 2 shows.

Figure 2: For most families, £4,000 a year is a very large proportion of disposable income or of existing savings

Source: RF analysis of 2013-14 Family Resources Survey

These questions of take-up are the reason for considerable uncertainty about the impact of LISA on the Exchequer, housing and levels of saving. But it seems likely to benefit the better off more – which might be considered odd given recent trends to remove cash support such as child benefit from higher earners – though with a novel policy focus on younger generations. And LISA may not be the end of the story. Future policy choices about the further evolution of auto-enrolment and whether to return to reforming the pension tax system could still radically change the make-up of UK savings, both in terms of how people save and how incentives and cash are targeted.