09 February 2017
Half a pension
A 50% solution for 50% of the people is not a solution
by Frank O’Nomics
Auto-enrollment looks like a success. With the end of company pension schemes which few businesses can still afford, there was a need to ensure that people were helped in building a pension pot for their retirement. By compelling companies to invest into a personal pension for all employees, alongside mandatory employee contributions, these pots are being built. The process has so far helped 6 million people to start saving for their retirement. However, while this is a great start there are fundamental flaws in a process which excludes a great many, and is destined to only generate about half the pension pot that most people are likely to need. Without some fundamental changes, those currently embarking upon their careers face an impoverished retirement – yet another prompt for intergenerational disharmony. So how big is the problem and what can be done to address it?
It is worth crunching the numbers to see what a typical target income should be in retirement and to what extent auto-enrollment will help to achieve it. It is not easy to work out as the amount needed depends on whether there are two household incomes, whether property is owned and area of residence. However, we need to start somewhere, so let’s use the back-of-a fag-packet calculations that the pensions minister Richard Harrington suggested at a recent TUC conference. If the average salary in the UK is £27,000 and in general people need a pension income two-thirds of their final salary, then the basic target should be £18,000. Of this around £8,000 will come via the state pension, so a pension pot will need to generate £10,000 to fill the gap. This may not sound much, but using current annuity rates a pension pot of between £200-250,000 is needed to generate that kind of income, especially if you want it to be inflation-protected. The problem is that, even with auto-enrollment, current levels of pension saving are unlikely to generate a pot of that size. A good rule of thumb is that you need to put into a pension plan a percentage of your salary roughly equivalent to half of your age when you start the process. Someone aged 21 years old then will need to save around 10% of their salary – sadly very few people start saving for a pension as early as that and when they do start the sums are much smaller.
Auto-enrollment has the virtue of getting people started on pension saving at an early age. As long as an individual is 22 years old and earning over £10,000, both they and their employer have to put 1% each into a personal pension. This rises over the next two years to 3% from the employer and 5% from the employee, so a 8% as a minimum of 8% will be saved. This process will get a lot of people started but will only be sufficient if individuals contribute more than this minimum and the problem is that they do not. There is currently a significant preference to save into an ISA rather than into a pension scheme. On the face of it this is very strange, given that the government still offers very attractive tax relief on pension contributions. A pension provider will claim 20% tax relief to be added to your investment for you. However, most people want to have the facility to access their money before retirement, hence the money going into ISAs. The Lifetime ISA being introduced in April, where the government will contribute £1 for every £4 invested, may do something to shift these flows, but most of this money will be used to build a deposit for a house rather than save for a pension.
Auto-enrollment will not, on its own, provide a solution based on current contribution levels. What makes matters worse is the number of people who are excluded from the process. £10,000 may not sound a lot, but the TUC estimates that this level effectively excludes around one-fifth of the working population. The auto-enrollment threshold was increased in line with the tax-free allowance. If it had been kept at the original £8,000, an extra 900,000 (mainly women) would have benefited. This is partly due to a high level of seasonal workers and the numbers working part-time, many of whom are women. Labour Peer Baroness Hollis argues that the pension system was devised by men, for men, and it is hard to argue with her. Many of the current pensioners in poverty are women due to their having taken career breaks which impacted upon their pension contributions. Even if someone has several jobs that take their earnings above £10,000, this does not help if no single job is above that level. 60-80,000 have aggregated earnings of over £10,000, but cannot auto-enroll.
The other big group that misses out is the self-employed. By definition they don’t have an employer who can make contributions on their behalf. Many self-employed people might regard their business as their pension, or have built up other savings and perhaps own property. However, this does not cover the new cohort of self-employed (Ryanair pilots for example) and on average they earn less than someone who is employed by a business. The Lifetime ISA might be the answer for some, but you can only invest in one of these if you are under 40, and most self-employed people are older than this. Former pensions minister Sir Steve Webb has proposed a solution of putting up Class 4 National Insurance levels paid by the self-employed to 12% from 9%, with the additional 3% going into a pension plan if the individual commits 5% (otherwise it goes to the Chancellor). This would leave the self-employed on equal terms, having 8% invested overall. However, is unlikely to meet with much support and will still exclude most of the self-employed who do not earn enough to trigger such NI contributions.
There you have it. The auto-enrollment process does not help the self-employed or the low paid, particularly the largest group in pension poverty, women. The process is still under consideration and one can only hope that there will be a decision to lower the minimum income and allow earnings to be aggregated. Even then the amounts being saved falls well short of what is needed so there will need to be additional encouragement to save into a pension. The government could of course increase the level of state pensions, but this would involve the government committing a further 2.5% of GDP to pensions (on top of the current level of 6%) and they really cannot afford to do that.
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