10 March 2016
What price a pension?
Save more or work forever
by Frank O’Nomics
Forget that Stephen King novel, or watching old Hammer Horror movies. If you really want to give yourself a fright, take a look at recent studies of the age at which today’s 22 year olds are likely to be able to collect a pension, or at least one that has any chance of them maintaining their standard of living. Former pensions minister Steve Webb has himself said that, when people see their predicted retirement age, they “get under the duvet and give up”.
Reports suggest that George Osborne has surfaced from beneath his duvet to abandon potential pensions reforms in the forthcoming Budget, due to the impact that they could have on saving. A number of studies, including one by Mr Webb, who is now policy director at Royal London, have this week pointed to a stark choice for the young – either face working until they are very old or save into a pension at a much higher rate. The fear factor is enhanced by further government studies which point to further increases in the age at which we will receive our state pension being linked to longevity. The state pension age is already expected to rise to 67 by 2028, and (according to the Office for Budget Responsibility) 69 by the late 2040’s. Former CBI head John Cridland is heading a review into the state pension age, which many believe will result in those entering the workforce today having to wait until their mid-70’s before receiving a state pension.
A great many of those currently in retirement, who either worked in the public sector or were in the high earning private sector, were fortunate enough to be in a defined benefit final salary pension scheme. These schemes typically paid the equivalent of 20% of earnings into a pension, which was sufficient for retirees to get 2/3 of their salary in retirement. In 2004, the Turner Commission calculated 2/3 of pre-retirement income as appropriate (and 50% for higher earners) as retirees do not pay national insurance, have no work related costs and have usually paid off their mortgage. The consequence of an ageing population, an increase in regulatory burdens and a fall in investment returns have meant that such defined benefit schemes are uneconomic and they have been closing for some years. To understand the extent of this problem look no further than weekend reports of the BHS pension scheme, which faces a deficit of over £571 million on current valuations. By the end of this year none of the largest 250 companies will be offering such schemes.
The replacement that most of the private sector has been paying into for some years was a defined contribution system, where companies paid into a pension that built up a pot of money that was used, on retirement, to buy an annuity which would provide an income for life. Clearly the size of the pot was very dependent on a number of variables such as the amount contributed, chosen retirement age, investment performance and annuity rates on retirement. Defined contribution schemes have typically generated much smaller pension pots and income, as contribution rates have been much lower (around 10% instead of 20% into defined benefit schemes), investment returns have been much lower, and annuity rates have fallen. The latter factor has been particularly important as lower interest rates have meant that 2 people with the same pot, retiring a few years apart, could face significant differences in income in retirement. More recent legislation on auto enrolment, introduced to help ensure that people were saving for retirement, typically involves an even lower contribution rate, with the statutory minimum level of 8% of salary not being in force until 2019. Obviously those in such schemes are going to have even smaller pension pots at any given retirement age and hence a much lower level of income.
So just how severe is the impact on potential retirement age? Steve Webb, in his new role at Royal London, has produced a paper (the Death of Retirement) which shows that someone on average earnings who starts saving on commencing work and who wants to retire on 2/3s of his final salary, will have to stay in work until the age of 77 if he contributes at the statutory minimum level. For those who start saving into a pension later, the targeted income level is not reached until 79 for those that start aged 35, or 81 for those starting to save at 45. ,The situation is even worse for those who are earning twice the national average income (which would currently be around £54,000) – they would have to work until their mid-80s to get 2/3s of their final salary.
There are additional factors that need to be considered. The above analysis is likely to be different for women given the likelihood of their having gaps in their contributions and there is the ongoing dilemma of how to make pension income last (using income drawdown, buying an annuity, taking a lump sum etc). Professor David Blake of the Cass Business School, who produced the Independent Review of Retirement Income (IRRI) for the Labour Party, has said that “people will find themselves in the same kind of control as a yachtsman in the middle of the Atlantic in a force nine gale”.
What are the alternatives to working longer? Well, some impact on income can be made by not having your pension index linked and not having a survivors pension on death. This could reduce the retirement age in the first example from 77 to 73, but there are obvious risks. The other alternative is to contribute more. Royal London calculate that for someone on average earnings to retire at 68 they would need to contribute 25% into their pension to be able to retire on 2/3 of their salary, or 13.8% to retire on half of their salary. These numbers are typically way in excess of current contributions, with the average worker putting in just 4.7% of their pay into a pension and most employers making a further contribution of less than 4%. The IRRI has suggested a target of 15% in total, close to double the current average level, and experts in the investment industry have agreed with this figure (but then they would, given the additional management fees that they would earn). This may be relevant and feasible to those who, while unable to generate sufficient savings for a property deposit, find that an increase in income in excess of inflation is giving them some available cash, but such levels are unlikely to be realised without a degree of encouragement from the tax system.
Most of us are more concerned about our current finances rather than those in the future, but would consider greater saving if there was a tax related inducement to do so. It seems that Mr Osborne has abandoned the pension ISA for now, and is reluctant to create a flat-rate of tax relief for pension contributions (which would benefit the lower paid), so for now the only way to encourage greater saving for retirement seems to be to publish the work of people such as Steve Webb. The other alternative is to get back under that duvet…
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