The Treasury is considering introducing flexibilities to the new Lifetime ISA savings vehicle, but lessons from the US show this could be dangerous, finds Sara Benwell
No one was shocked when George Osborne used the budget to announce a new Lifetime ISA product. In fact, most people were simply relieved that we’d dodged a wholesale shift from pensions to ISAs via the Pensions ISA.
Lessons from the US demonstrate why we should avoid 401k style Lifetime ISAs
However, industry experts are concerned about the consultation to introduce 401k-style flexibilities that would allow members to take out loans against long-terms savings held in LISAs.
The Chancellor is exploring whether the Lifetime ISA should follow the US 401k model, where some savers can borrow up to 50% of their fund (up to a maximum of $50,000) and pay it back over a set period of time without incurring a penalty.
This freedom is popular in the US with 10% of 401k participants initiating a new loan last year. Overall, around 21% of participants have a loan outstanding.
But there is evidence that this may be to the detriment of long term pensions saving.
Lesson one: Who is taking loans?
In the US the evidence suggests that it is those people with the lowest savings who are taking advantage of 401K loan flexibilities. This is a worrying trend, and one that we would not want to see duplicated in the UK.
Furthermore, over half of the people who have outstanding loans have taken advantage of the freedoms more than once. Taking out multiple loans against the same pension pot will not only increase the lack of earnings in the period, but also increase the chances of savers defaulting against the loan.
Flexibility can lead to a slippery slope to more and more borrowing”
Richard Parkin, head of pensions at Fidelity International commented: “Over half of [participants] have more than one loan, suggesting that the flexibility can lead to a slippery slope to more and more borrowing and facilitate a group who are very heavily reliant on loans.”
Tom Selby, a senior analyst at AJ Bell, added: “While the majority of US 401(k) savers who can borrow from their fund haven’t drained their pots, about a fifth have loans outstanding, worth on average 11% of their total pot.
“These are not small numbers, especially when you consider the majority of the UK population is already failing to put enough to one side for retirement.
“It is particularly concerning that those with the least money saved and on the lowest salaries who take out loans, tend to take out a bigger proportion of their pot.”
Lesson two: What are the implications for their investments?
In the UK market, where DC pension pots are already small, cumulative interest pays a significant role in determining what someone’s final retirement savings picture will look like. The problem with allowing people to borrow against long term savings is that they will no longer get investment returns on the money that has been removed. This can significantly deteriorate the value of someone’s savings over time.
In the long run this is likely to drag on overall investment growth”
Parkin said: “You could argue that it’s better to borrow from yourself than from a bank and, in theory, this is true. The rate of interest you pay is likely to be lower, you won’t get credit scored and any interest that is paid goes back into your account. However, when you borrow from a 401k plan, what you’re actually doing is redeeming investments in your account and then repurchasing them using the loan repayments.
“So while you’re earning interest on the amount withdrawn, you’re foregoing investment returns. In the long run this is likely to drag on overall investment growth therefore impacting on the potential future benefits from the plan.”
Another worrying trend in the US is that people who take these loans often decrease future contributions or stop them altogether. Fidelity figures showed that 25% of those taking out a loan reduced contributions in the following five years with 15% stopping entirely.
If someone depletes their savings and then ceases contributions their retirement picture could quickly start to look pretty bleak.
Lesson three: How are they paying them back?
Defaults rates are in the US are low, but this is largely because repayments are made via payroll and deducted automatically. However when an individual leaves a job with a loan still outstanding defaults are far more common.
I think we have to be very cautious about implementing a loan facility where there is no existing collection mechanism”
In that situation the saver has just 90 days to repay the loan. This can cause problems, particularly if the individual is not leaving by choice. If the loan is not repaid then the outstanding balance is treated as a withdrawal, is taxed and has a 10% penalty applied, putting an even bigger hole in the participant’s retirement plans.
As the Lifetime ISA is unlikely to be funded from payroll deductions the risk of default will inevitably be higher.
Parkin said: “So what does this mean for the Lifetime ISA? I think we have to be very cautious about implementing a loan facility where there is no existing collection mechanism such as payroll deduction. What would stop individuals from simply contributing then borrowing the money back and repaying through existing contributions? That doesn’t seem like something that should be supported by government subsidy.”
A concern for pensions saving
Initially this may not seem like a big concern, particularly since the Lifetime ISA is distinct from auto-enrolment savings in the UK. But there are already concerns that people might choose to prioritise a Lifetime ISA over pensions auto-enrolment saving.
It is worrying enough that a LISA will let people raid their savings to buy a home but, in a market where getting on the property ladder is an understandable concern for young people, this flexibility makes sense. Adding a loan feature could further weaken the product’s suitability for longer-term savings and leave young people without sufficient funds for retirement.
George Osborne needs to think very carefully”
The government is expecting LISAs to be on the market by 2017 and there is a strong possibility that young people might be tempted by a product that gives them a government bonus when saving for a property.
However, the product has also been billed as a pensions saving vehicle and we need to be careful that the risks to people’s long-term savings are contained. The evidence from the US shows that adding extra flexibilities will only increase that risk, so George Osborne needs to think very carefully before deciding to emulate the 401K model over here.
After all, whether young people are saving for a property or a pension they need their savings to earn interest for them over the longer term, not provide an emergency cash fund in the short term.