Having enough money to live on in retirement should be something that everyone desires, yet in the UK we simply do not save enough to even get close. A person on average earnings is recommended to have an income in retirement of around £16,000 of which the state pension would contribute a maximum of £7,420. That leaves a gap of some £8,500 to come from private pensions saving. Yet with an average pension pot on reaching retirement of just under £37,000, an inflation linked annuity would generate around £1,340, less than a sixth of what is needed.
With the proportion of the population over 65 likely to reach nearly a quarter by 2050, such undersaving is a timebomb for the public finances. If people cannot afford to pay for their care or even their heating in their old age the government will be under huge pressure to step in. The Office for Budget Responsibility calculates that the cost of pensions, long term care and pensioner benefits will rise from around 8.4 per cent of GDP now to 12.4 per cent of GDP by 2050.
This is why the government introduced auto-enrolment with 8 per cent of income to be saved by a combination of employee (4 per cent), employer (3 per cent) and the government (1 per cent). Unfortunately, in a report we publish today, we show that even if someone saves for 40 years uninterrupted at this rate they are likely to generate little more than half of the money they need to meet the recommended retirement income. Those type of numbers have also been confirmed in a recent study by the Pensions Policy Institute, where they calculate that even with a 48 year contribution period a median earner would have only a 49 per cent chance of achieving their target retirement income.
All of that assumes people stay in the system. Auto-enrolment has been successful so far with 90 per cent of people opting to stay in, but it has been focused on large firms. The take-up for smaller firms is likely to be smaller. The real flaw with the current system though is that people have the right to opt out.
We calculate that, to even have a chance of generating a sufficiently large pension pot, the contributions would need to rise to around 14.5 per cent at current annuity rates for a person on average earnings. Were the government to try and impose such a contribution rate, even if it were to be phased in, the opt-out rate would be likely to climb sharply, as people decided they simply cannot or do not want to put away that much of their income into a pension.
If they choose to do that, however, other taxpayers would have to pick up the bill. In our view, saving for a pension is as necessary as paying tax or national insurance contributions. If we do not do it, many will face a retirement in poverty.
We believe the minimum contribution to a pension needs to rise from the current 8 per cent to around 12 per cent if people are to save enough. To ensure that the increase sticks the government needs to move from a system of auto-enrolment to one of compulsory contributions. We would phase in the increase over a period of 5 years using the same contribution ratios.
An individual’s contribution would therefore rise from 4 per cent to 6 per cent, the employer from 3 per cent to 4.5 per cent and the government from 1 per cent to 1.5 per cent.
The increase in contributions would be subject to the individual having a sufficient increase in their income. Given that this would be 0.4 per cent per annum, into a period of economic recovery, we believe this achievable. Despite the current debate over the cost of living we would argue that the process needs to start as soon as possible if people are not to face a sizeable shortfall in retirement.
Australia is in the process of implementing a similar change with a compulsory system and this has seen saving rates in the country rise significantly in recent years, so we know it is achievable.
We make two other key recommendations in the report. First, we propose a radical reform of the annuity market, with the government to issue annuity type government bonds with a minimum duration of 15 years. Insurers would then offer annuities that would start only after the bond had expired. It takes almost all of the interest rate risk out of the equation and allows insurers do what they do best – insure lives.
Second, we believe people should be given much more flexibility with their pension pots. Rather than being forced to buy an annuity or have their returns linked to an annuity as currently, we propose that up to half of the income above the state pension, up to the £20,000 minimum income requirement, could be taken from the yield on an equity fund. Most equity income funds yield considerably more than government bonds currently and you would also be able to keep the pension pot as well rather than spend it all on an annuity.
If our proposals were adopted, people would enter retirement with more savings and better ways to convert those savings into retirement income. Then we really could claim we had defused the pensions time bomb.