 By Dr Ros Altmann, Director-General of the Saga Group
At the moment, there is huge excitement about the prospect of millions more workers starting to save in a workplace pension scheme. Automatically enrolling all workers into pensions is a policy originally recommended by the Pensions Commission in 2006 and is intended to result in much higher pension income for future retirees. It is assumed that the power of inertia will mean most workers do not opt out, even though they can do so. The expectation underpinning this policy is that more pensioners will have private pensions in addition to their state pension and will, therefore, have better living standards in later life. Contributions will benefit from tax relief and long-term investment returns that will build up large pension funds for workers.
This all sounds great, but I fear that auto-enrolment has not sufficiently factored in consideration of the adequacy of contributions. So far, it is all about getting people to put money in, rather than how much money those contributing will get out as a pension in future.
In fact, it could well be the case that workers will be lulled into a false sense of security about the adequacy of their pension arrangements. Many workers seem to assume that, however much or little they are paying into a pension scheme, their future retirement security is assured. But it is clear that the official minimum contribution levels which amount to 8% of 'band' earnings is most unlikely to deliver much pension income. Will workers understand this? Who will explain things to them?
It is quite astonishing how little most people understand about pensions. For example, most do not realize that just putting money into a pension fund will not actually deliver them an income in later life. They focus on the size of their pension fund, but of course, at retirement, they then have to decide how to take an income from this fund. In reality, the ultimate pension paid out will be determined by four factors - the level of contributions, the investment returns achieved, the fees paid out and the annuity rate on retirement.
Unfortunately, most people do not understand the risks of pensions and just assume that any forecasts they are given will actually be realized. But this has often not happened in the past. Several studies have been done which assume that auto-enrolment will deliver good pensions for those who do not opt out. This may well not be the case.
For example, the research that has endorsed the current policy has been based on relatively optimistic investment return expectations and has failed to factor the cost of annuities properly into the forecasts. Predictions of the future pension income assume annuity rates that are very much out of date. Using recent returns as a guide to the future and current annuity rates, these forecasts of pension adequacy would be far too optimistic. Annuity rates have plunged in the last couple of years, as a result of the Bank of England's policy of Quantitative Easing, and this means that even if pension investments perform in line with assumed returns, future pension income will be at least 20% lower than forecast.
Therefore, it will be very important for pension scheme members to receive regular updates of how their pension investments are performing and what their future pension income is likely to be. This will help them check whether they are on track to achieve the income levels they desire and have a chance to adjust their contribution levels and investment approach over time.
It is also important to help workers understand that the minimum levels of contributions will not be sufficient to ensure good pension income. They need to build on those minimum levels over time. For example, supplementing the auto-enrolment statutory amounts with a policy of 'Save More Tomorrow', in which some or all of any future pay rise is automatically earmarked for pension contributions, would ensure that the minimum levels are increased through workers' lives. A general guideline is that a pension worth half of a workers' salary would need contribution levels of well above 20% of salary each year, if the pension starts from around age 65. For most workers, this will not be possible, so they will need to understand that pension planning will have to be more flexible than in the past.
If their pension plans are not on track to deliver the desired retirement income, and they cannot or will not increase contributions, then workers could consider delaying the starting date for their pension, rather than choosing a specific retirement date when young and relying on it.
Workers will need to regularly assess the adequacy of the pensions they might be on track to receive. Encouraging them to check their plans regularly and be prepared to adopt a more flexible approach to level of contributions, investment allocations and start date for their pensions will help reduce unrealistic expectations and ensure people plan more appropriately for their later life income. Otherwise, there is a significant risk that auto-enrolment will not really help solve our pensions crisis.
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