I’ve spoken at a number of pension seminars this year (I know; lucky me), but what I’ve noticed is that when many other attendees and speakers at those conferences talk about the 2012 changes they often make the remark that it will be the first time that every employee in the country will have a decent company pension available to them. This is often claimed to be likely to be particularly beneficial for those in the ‘target market’.
I always find myself wanting to interrupt when I hear such sentiments expressed as I think there’s a world of difference between a ‘pension’ and a ‘decent pension’.
The three main changes coming due to the current reforms are the stopping of the rot in the basic state pension from 2012; the changing of the State Second Pension (S2P) from providing earnings-related benefits to providing a flat-rate pension; and the automatic enrolment of unpensioned employees into ‘good’ occupational schemes, or the new Personal Accounts scheme as a default.
For those employees whose annual earnings lie in the range £10,000 to £15,000 (the target market) the first two changes will have a significant impact on their pensions when described in terms of what governments like to call ‘replacement rates’. (See the BeeLine entitled Personal Account Sales Aid if you want to see numerical examples of why that’s the case.) Stopping the Basic State Pension from losing value when compared to average earnings levels every year and making the State Second Pension more redistributive through the provision of a flat-rate top-up to the basic pension will mean someone earning the equivalent of £10,000 today throughout a working career starting in 2012 will end up with a pension of £8,400 a year in today’s terms. A ‘replacement rate’ of some 84%.
But auto-enrolment into forty years of savings through, say, the system of Personal Accounts will only improve that replacement rate by eight percentage points to 92%. An extra £800 a year pension in today’s terms in return for forty years of persistent saving. It doesn’t seem much, but we need to realise that for someone earning just £10,000, over half their earnings will not be pensionable under the terms of this new scheme. So an 8% overall contribution will in practice be just a little less than a 4% contribution when compared to their total salary; with the total weekly pension contribution from the employee, the employer and the taxman amounting to something like £7.70. Or to put it another way, not very much.
Years ago, back in the 1940s and 1950s when people were thinking seriously about the post-war demographics and pension saving, the view was that a replacement rate of two-thirds of earnings levels at retirement would represent a ‘decent’ pension. Company pension schemes and government-run pension schemes for public sector workers aimed to achieve this 66% replacement rate and in many cases succeeded in doing so. Back then it was thought that the pension legislation should cater for the self-employed in the same way that it did for employees and Retirement Annuity Policies (the precursor to today’s Personal Pensions) were supported by tax legislation aimed at providing a similar replacement rate of 66%.
It was no accident that allowable Retirement Annuity (and pre A-Day Personal Pension) contributions were fixed at 17.5% for the under 35s with allowable increases on a sliding scale at fixed age points of 20%, 25%, 30%, 35% right up to 40% from age 61. 17.5% of earnings was the contribution level that actuaries in those times thought sufficient if paid from age 16 through to age 65 to produce a pension of two-thirds; simple as that.
Many were confused by the messages put out by that legislation and it led to a common misconception that with Retirement Annuity contracts (and Personal Pensions after them) it was necessary to increase your contribution level as you got older. That wasn’t the case. The higher rates of contribution allowed to people as they got older were to allow for the fact that many would start saving later in life. Not everyone would be self-disciplined enough to put aside 17.5% of their income every year from age 16 to age 65. Indeed, someone who did start saving at the rate of 17.5% from age 16 and increased their contribution level to the maximum allowed as they aged could have achieved replacement rates of well over 100% had they wished to. Retirement Annuity policies and pre A-Day Personal Pensions were not restricted to a maximum pension level as occupational schemes were.
When judged by outcomes in terms of the replacement rates that the current reforms will achieve it’s likely that those in the unfortunately-named target market will see great improvements over time. Not through pension saving, as such, but through structural changes to the state pension schemes. Those that look most likely to be the losers through these changes are, of course, those who are too rich to be classed as being poor, but too poor to be classed as being rich. As usual, those caught in the middle.
My guess is that pension saving will become more important than ever for those who in the past have been able to rely on earnings-related state pensions or increases to their private sector occupational or personal pension schemes through the process of contracting-out. The Government may be able to rightly claim that replacement rates for poorer employees have been improved, but it seems a shame to me that these changes that will come hand in hand with such a lowering of the perceived benchmark for pension saving.
The 8% contribution level being set for Personal Accounts gives all the wrong messages to pension savers of the future. The people who designed our pension system over fifty years ago knew what they were doing when they set the bar at the 17.5% level. Today, if they were setting it in the light of modern understanding of likely mortality levels I’ve no doubt they would choose to set the bar higher, not lower.
21 July 2008
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