Lifetime Pension Contribution

A Lifetime Pension Contribution (LPC), aimed primarily at young consumers (in their 20ʼs), would provide a guide to the monthly contribution required over a full working life to achieve a reasonable retirement income when combined with the State pension.

1. 5. All our RoTs, including the LPC, assume contributions commence at age 22, so they are internally consistent.

2. 6. We envisage that the LPC (and the RITs) would increase annually in line with Average Weekly Earnings (AWE) in order to maintain their value relative to general earnings growth, while noting this is part of the current “triple lock” for increases in State pension.

3. 7. We derived an illustrative LPC based on a pre-tax RIT of £18,000 (about 2/3^rd of annualised AWE), inclusive of State pension and payable from State Pension Age (SPA) of 68, which we believe is a reasonable target pension for the average consumer to aspire to. However, the calculated LPC is £525 per month, or the monthly equivalent of around 23% of AWE which, even after allowing for the employerʼs contribution and tax relief, is likely to be unaffordable for many consumers, leading to disengagement. We considered later the implications so arising.

Retiring Later than Age 68

1. 8. If the consumer continues to make DC contributions beyond age 68 and defers drawing State pension until the DC pension commences, a simple adjustment to the LPC can indicate the reduction in monthly contribution required to achieve the same RIT of £18,000 at the later age. For example, with a LPC of £525 the deduction is £55 for each year between 68 and retirement age. The required monthly contribution for retirement at age 71 is therefore about £525 less (3 × £55) = £360, or the monthly equivalent of around 16% of AWE.

Rules of Thumb for Target Pension

1. 9. Another RoT aimed primarily at young consumers is to estimate the target pension at age 68 (before allowing for State pension) based on their current level of contributions (inclusive of any employer contribution). The RoT is target annual pension = 1.5 times the current annual contribution. This can be used to test the adequacy of current contributions and make adjustments accordingly.

2. 10. For retirement at other ages, the multiple changes, e.g. 1.5 becomes 1.7 (for retirement at 70) and 1.2 (for retirement at 65).

Rules of Thumb for Older Consumers

1. 11. Older consumers can use the above RoTs, in conjunction with another that helps them check the adequacy of their accumulated DC funds against a “benchmark fund”, so that action can be taken accordingly. For example, if aged 41–50, the benchmark fund is calculated as the current annual contribution × (age – 20). So if a consumer aged 50 was contributing the LPC of £525 per month, the expected DC fund at age 50 would be derived as £525 × 12 × (50 − 20) = £189,000. If the actual fund were less than this benchmark, the consumer could consider paying additional contributions to bridge the gap, as well as continuing to contribute the LPC.

2. 12. We strongly support the development of the Pensions Dashboard, which would facilitate the comparison of what may be multiple DC funds against a consumerʼs benchmark fund. Indeed, one idea would be to show a benchmark fund on the Dashboard.

3. 13. On nearing retirement, it becomes increasingly important to adopt a personalised approach, taking into account individual circumstances. This will need emphasising as part of the communication of RoTs.

Variation in Contributions

1. 14. Our RoTs assume consumers will contribute a constant percentage of earnings from age 22. In practice contribution patterns will vary; for example, some may wish to contribute lower amounts initially and correspondingly larger amounts in later years. The RoTs can still be used, with the benchmark funds helping to guide people over time.

2. 15. Adjusting contributions to reflect investment experience enables a consumer to narrow the range of uncertainty in retirement income, but creates a variable and uncertain pre-retirement income.

This is one example of the trade-offs involved, and we suggest more work is undertaken to develop further RoTs to assist consumers in managing their consumption over the entire period pre- and post-retirement.

Affordability

1. 16. The minimum employer contribution under automatic enrolment (A/E) is 3% from April 2019. A phased increase in employer contribution to 6% (with total contributions rising to 12%), as proposed by the PLSA, would provide some assistance in making DC pension provision more affordable for consumers. We also support the Governmentʼs proposal to remove the lower earnings threshold when calculating qualifying earnings. Widening the scope of A/E to include the self-employed should also be a priority.

2. 17. A/E was never intended to be sufficient to provide an adequate retirement income, and our analysis suggests that would remain the case even after an increase in A/E contributions to 12%. Additional voluntary contributions should therefore still be anticipated.

3. 18. The LPC is sensitive to the choice of RIT; we used £18,000 by way of illustration. We believe the LPC should be based on an appropriate RIT, derived after widespread discussion, and that if the resulting monthly contribution is deemed unaffordable for general use, then the LPC should be reduced by assuming consumers work longer and retire later. This should be made clear to consumers so that their expectations are properly managed.

4. 19. Part of the problem with affordability lies in the inefficiencies of the individual DC market. We therefore suggest there is a need to find ways to harness bulk purchasing powers, along with the benefits of pooling investment and mortality risks. This would make DC pension provision more affordable and predictable for the consumer. The growth of master trusts should lend itself to the development of such solutions, as would the introduction of collective DC schemes.

5. 20. One aspect of particular concern is that the cost of individually purchased annuities is currently around 15–20% higher than the terms typically available to defined benefit pension schemes for bulk purchase under a buy-in or buy-out.

6. 21. Low interest rates are a major reason for the high cost of pension provision. While future rates cannot be predicted, the unravelling of the effects of quantitative easing (QE) should lead to an increase in interest rates, other things being equal. A rise in long-term interest rates could significantly reduce the cost of pension provision, e.g. an increase to say 4% p.a. from the current (March 2019) level of around 2% p.a. would reduce the LPC, perhaps by around 30%.

7. 22. The issue of affordability is a serious one and requires widespread discussion. We believe the concept of the LPC can provide a useful platform for promoting such a debate, having regard to the various issues outlined above.

Rules of Thumb in Practice

1. 23. We see merit in developing a single LPC, in order to create the maximum impact. The LPC would act as a benchmark of pension cost, increasing annually in line with AWE and adjusted periodically for other factors, such as interest rate changes. Promoting the LPC in the national media would help cement it in the general psyche.

2. 24. We suggest that market research is undertaken to test whether the RoTs, including the LPC, would be helpful. The research can also address the means of communicating the RoTs. This might include the development of an independently branded smartphone app to facilitate their use.

3. 25. RoTs will be more effective if used in conjunction with “nudges”, i.e. promoting actions at key “teachable” moments.

RIT

1. 2.2. The choice of RIT will be a major factor in determining the target fund. For illustration purposes, we have assumed that the consumer chooses a RIT of £18,000, on the basis that this is approximately two-thirds of annualised Average Weekly Earnings (AWE) of £27,456Footnote ¹⁰ , and two-thirds is the Target Replacement Rate suggested by the Pensions CommissionFootnote ¹¹ at that level of earnings. There is considerable debate as to whether replacement rates are useful given the wide range of individual circumstances, but for present purposes this is a convenient starting point.

2. 2.3. We have further assumed that the consumer will earn a full State pension of about £8,500, so that the retirement income required from the target fund is approximately £9,500 per year.

3. 2.4. We also assumed that the RIT and State pension will increase annually in line with AWE in order to maintain their value in real terms (and noting AWE is part of the current “triple lock” for increases in State pension).

4. 2.5. We have anticipated that each member of a household will aim to provide for their own RIT, with no contingent pension payable to a spouse or dependant after death. We recognise that many household costs are shared, and this might influence the choice of RIT, but each consumer needs their own RIT for planning purposes.

5. 2.6. Finally, we have assumed the RIT is a gross amount, i.e. before deduction for tax.

Retirement Age

1. 2.7. The age from when the retirement income is to commence is very significant, since an earlier commencement age will require higher contributions. A discrete retirement age is becoming much less common nowadays, with flexible working patterns and the removal of an employerʼs right to force its employees to retire by virtue of age. Nevertheless, an assumed single retirement age is the simplest way to define retirement objectives.

2. 2.8. We have assumed that the consumer will retire at SPA, since the commencement of the State pension will make retirement much more affordable for our target group at this time.

Retirement Objectives

1. 2.9. Given the options now available at retirement, as discussed in our review of the decumulation market ^{Footnote 12} , we also need to consider the extent to which the consumer wishes to prioritise the following competing objectives:

   1. (a) The target income will continue for life (security);

   2. (b) The target income is protected against the impact of inflation (inflation protection);

   3. (c) Value for money is achieved in the event of early death, or that specific legacy intentions are met (legacy needs);

   4. (d) There is flexibility to vary the income to suit changing circumstances (flexibility);

   5. (e) Whether the consumer has additional requirements at retirement, such as to pay off debt or finance a holiday or another major discretionary purchase (cash needs).

2. 2.10. Can we choose a single measure of target fund at retirement that represents a fair balance of the above objectives (noting that objectives may be unclear for young consumers and can change over time)? If we could, this would facilitate the development of RoTs.

3. 2.11. We explore this further in Appendix A, concluding that our preference is to base the target fund on the estimated cost of purchasing a single life index-linked annuity, for the following reasons:

   • It satisfies the requirements of security and inflation protection, by providing enough money to purchase a guaranteed index-linked income for life;

   • It provides a reasonable fund for those wishing to pursue drawdown, where flexibility and legacy needs are more significant considerations, including perhaps some immediate cash requirements.

4. 2.12. We considered a lower target fund, but noted that this would not enable a consumer to fully satisfy the requirements of security and inflation protection, while also not providing enough to enable drawdown with sufficient confidence of the money not running out in retirement.

5. 2.13. We also considered adopting a higher target fund, which would provide an enhanced ability to meet the various potential objectives listed above, but rejected it because it would significantly increase the calculated cost of pension provision and might be deemed overly prudent.

Target fund

1. 2.14. As explained above, we have based the target fund at retirement on the cost of purchasing a single life, index-linked annuity using the approach described in Appendix A.

2. 2.15. The target fund will vary according to the consumerʼs current age, due to projected improvements in mortality. For a consumer currently aged 22, with a SPA of 68, the target fund at retirement age 68 is £310,000. This is the fund in present day money terms and so will increase annually in line with AWE.

Calculating the LPC

1. 3.6. By way of illustration, we derived the LPC based on what we regard as a reasonable target for an average consumer: a RIT of £18,000 (about two-thirds of annualised AWE) payable from age 68, requiring a DC pension of about £9,500 after allowing for a full State pension. As explained in section 2, this requires a target fund of £310,000 at age 68 in present day money terms.

2. 3.7. We calculated the LPC using various alternative assumptions, with the results being set out in Tables 1 and 2 and, as explained later, concluded that a single representative LPC would be £525 per month.

   Table 1. LPC under different investment scenarios, real earnings growth 1.5% p.a

   

   Table 2. LPC according to different assumed real earnings growth (Central assumptions)

   

Variation in Assumed Investment Return

1. 3.8. The great majority of consumers are invested in their schemeʼs default lifestyle strategy, which for an increasing number of schemes targets drawdown at retirement. This is the approach underpinning our Central assumption, which is set out in Appendix B along with the alternative assumptions referred to below.

2. 3.9. The Lower and Higher assumptions also target drawdown but with assumed investment returns 0.5% p.a. lower or higher respectively than the Central assumption.

3. 3.10. The Annuity assumption assumes the same investment return as Central prior to the lifestyle period (the period of de-risking prior to retirement), and then targeting an annuity purchase at retirement.

4. 3.11. We show in Table 1 how the LPC varies under different investment scenarios with assumed real earnings growth of 1.5% p.a., based on contributions commencing from age 22.

Variation in Real Earnings Growth Assumption

1. 3.12. Table 2 shows how the LPC varies according to the real earnings growth assumption.

Conclusions

1. 3.13. On the basis of a single LPC being adopted (which has considerable merit for a RoT), we suggest £525 as being an approximate average of the Central and Annuity amounts with real earnings growth of 1.5% p.a. and assuming contributions commence at age 22, acknowledging that drawdown is a very popular alternative to annuitisationFootnote ¹³ . In addition, £525 is broadly equivalent to an average of the various amounts in Tables 1 and 2, which indicates it is representative of the range of alternative assumptions that we have illustrated.

2. 3.14. The assumptions underlying the calculation of the LPC (LPC assumptions), as a blend of the Central and Annuity scenarios, equate to an assumed average real return before retirement of about 2.65% p.a. as noted in Appendix B. Since we are assuming real earnings growth of 1.5% p.a., this implies an investment return net of AWE and charges of only 0.4% p.a., a reflection of the current low interest rates.

3. 3.15. The LPC assumptions were also applied for deriving the other RoTs in this paper.

4. 3.16. £525 is the monthly equivalent of around 23% of AWE, and an even higher percentage for a consumer currently earning less than that and who aspires to a RIT of £18,000. This is clearly a very steep cost, alleviated to the extent that there is an employer to share some of the burden, and of course tax relief.

5. 3.17. Adopting a LPC at that level is likely to disengage consumers, and we consider in section 7 the issues arising regarding affordability.

Benchmark Funds

1. 5.2. An older consumer can use the same RoTs described in sections 3 and 4, provided they also check if they are “on track” according to the size of DC fund anticipated at any given age (the “benchmark fund”). Chart 1 shows the benchmark funds assuming contributions commence from age 22, to provide a target pension of £1,000 from age 68. The target pension RoT tells us that the required annual contributions will be £1,000/1.5 = £666. The benchmark fund at any specific age would increase annually in line with AWE, in the same way as the LPC.

2. 5.3. Inspection of the benchmark funds reveals the potential RoT shown in Table 5. With an assumed “real” investment return of only 0.4% p.a. (see section 3.14), the impact of investment growth is negligible up to age 40 and can therefore be ignored, as revealed by the formula below (noting we have assumed contributions commence at age 22). At later ages, the impact of investment growth remains modest and is accounted for by applying a lower deduction to the consumerʼs age.

   Table 5. Benchmark fund rule of thumb for contributions commencing at age 22

   

3. 5.4. For example, referring to Chart 1, we expect a fund at age 45 of about £666 × (45 − 20) = £16,600 (compared with £16,000 in the Chart).

4. 5.5. Let us suppose that a consumer aged 45 is contributing £2,000 per year, aiming for a target pension at age 68 of £2,000 × 1.5 = £3,000. The benchmark fund is £2,000 × (45 − 20) = £50,000. The consumer has total DC funds of £42,000 and so has a shortfall of £8,000; this can be funded over a period of time in addition to continuing the annual contributions of £2,000. In practice, all these figures would be adjusted for increases in AWE.

5. 5.6. The same consumer contributing our illustrative LPC of £525 per month, to provide a RIT at age 68 of £18,000 including State pension, would expect to have a fund at age 45 of £525 × 12 × 25 = £157,500.

6. 5.7. Implementing a Pensions Dashboard will be very important in enabling people to quickly establish their total DC savings in order to assess these relative to the benchmark funds. Indeed, one idea would be to show a benchmark fund on the Dashboard.

Chart 1. Benchmark fund for pension of £1,000 at age 68.

Variation in Earnings Growth

1. 5.8. We have assumed that a consumerʼs contributions and target pension will increase in line with AWE, so what are the implications if that were not the case in practice?

2. 5.9. If the consumerʼs earnings grow by more or less than AWE, then that will cause a divergence from the benchmark fund, which will be revealed when a check is made. It is possible that the consumer may wish to adjust the target pension though, to reflect lower (or higher) aspirations arising from the current level of earnings.

Consumers Closer to Retirement

1. 5.10. On nearing retirement, it becomes increasingly important to adopt a personalised approach, taking into account individual circumstances. So what are the implications of such people using the RoTs?

2. 5.11. If we assume that life expectancy will continue to increase over time, then older consumers have lower life expectancies than their younger counterparts and hence lower benchmark funds (and correspondingly lower contribution requirements). This is illustrated in Chart 2 for a target pension of £1,000 per year from age 68, which compares the benchmark fund at each age for a consumer who has reached that age in 2018 versus a consumer who is aged 22 in 2018.

3. 5.12. It can be observed that the difference is modest up to age 45, and then the figures start to diverge. For consumers older than 45 who do use the RoTs, the calculated costs will be overstated.

4. 5.13. This in itself may not be deemed a bad thing, but nevertheless it will be important when communicating the RoTs to emphasise that for consumers approaching retirement it is important to have regard for individual circumstances.

Chart 2. Benchmark fund – generational impact.

Non-Uniform Contribution Patterns

1. 6.2. It is likely that a significant number of consumers will not contribute a uniform percentage of earnings. For example, some may prefer to pay lower contributions in the early years, perhaps to save for a property purchase or to leave enough income to bring up a family, increasing their contributions in later years when it becomes more affordable.

2. 6.3. Our RoTs can still be applied in such circumstances, since the benchmark funds will indicate the extent of the shortfall and thereby provide a guide to the additional contributions needed in later years. A similar approach can be used by someone who has had a career break, e.g. to care for a young family or elderly relative.

3. 6.4. Table 6 illustrates the importance of starting to contribute early. While we could derive a RoT from these results, it would be inconsistent with the rest of our RoTs which are internally consistent based on contributions commencing at age 22. Also, because of A/E it is unlikely that consumers would make no contributions from age 22, although the level of contributions may be relatively low.

   Table 6. Required monthly contribution according to different starting ages. Using life expectancy for age contributions commenced

   

Adjusting Contributions to Reflect Investment Experience

1. 6.5. Taking some investment risk is necessary to make saving for retirement affordable, but that requires contributions to be reviewed and adjusted as necessary, in order to stay on track to achieve a given retirement pension.

2. 6.6. Chart 3, showing net income by age, illustrates what happens if contributions are not adjusted to reflect investment experience. Stochastic projections have been used,Footnote ¹⁴ and the chart shows the median and percentile outcomes. All figures are expressed in present day money terms.

3. 6.7. The consumer earns £27,000 and contributes £525 per month, resulting in an income, net of pension contribution but before tax, of almost £21,000 for the whole period from age 22 to 68. The target pension at age 68 is £18,000, which is assumed to be secured with an annuity and thereby be constant in retirement. While the median pension from age 68 is £18,000, there is a wide range of uncertainty around that figure.

4. 6.8. Chart 4 is based on the same situation, but where contributions are adjusted annually to reflect investment experience, capped at an illustrative 30% of earnings (results for a lower cap will be intermediate between Charts 3 and 4). The level of uncertainty in retirement income is greatly reduced, but at the expense of an uncertain and volatile pre-retirement income.

5. 6.9. This illustrates the trade-off between pre- and post-retirement uncertainty. In fact, further analysis, which is not presented in this report, shows that removing all post-retirement uncertainty is not even achieved if the consumer could afford to contribute 100% of earnings where necessary.

Chart 3. Contributions a constant % of earnings from age 22 to 68. Target pension £18,000.

Chart 4. Same as Chart 3, but contributions adjusted annually (cap of 30% earnings).

Further Comments

1. 6.10. In practice, the consumer could alleviate any financial pressures pre-retirement by lowering the target retirement income or increasing the planned retirement age.

2. 6.11. The entire period before and after retirement can be viewed as a continuum, with the consumer seeking to smooth consumption, while avoiding surprises and periods of relative poverty. We suggest that further work should be undertaken using the above type of analysis to explore the trade-offs involved, which could lead to the development of further RoTs for both the pre- and post-retirement periods.

Automatic Enrolment

1. 7.2. The minimum employer contribution under automatic enrolment (A/E) is 3% from April 2019. A phased increase in employer contribution to 6% (with total contributions rising to 12%), as proposed by the PLSA⁵, would provide some assistance in making DC pension provision more affordable for consumers.

2. 7.3. We also support the Governmentʼs proposal to remove the lower earnings threshold when calculating qualifying earnings.

3. 7.4. Widening the scope of A/E to include the self-employed should also be a priority.

4. 7.5. A/E was never intended to provide sufficient contributions to achieve an adequate pension¹¹, and voluntary contributions were envisaged to make up the shortfall. This would remain the case if our illustrative LPC of £525 per month were adopted.

Retirement Age

1. 7.6. Contributing longer and retiring later would clearly make retirement more affordable. For example, using the RoT from section 4.7, the LPC for a RIT of £18,000 from age 71 is about £525 − (3 × £55) = £360, or around 16.0% of annualised AWE.

Choice of Target Pension Benefit

1. 7.7. The amount of the LPC is very sensitive to the choice of RIT on which it is based, as illustrated in Table 7.

   Table 7. LPC for various choices of RIT

   

2. 7.8. Further debate will be needed to determine an appropriate choice, and the PLSAʼs proposed RITs (not available at the time this paper was finalised) can contribute to such a discussion.

3. 7.9. One consideration is that retirement expenditure is determined by household rather than individual, and there is plenty of evidence to suggest that a coupleʼs retirement expenditure is significantly less than twice that of a single pensioner. How that might translate into the choice of RIT for determining the LPC merits further analysis.

4. 7.10. We believe the LPC should be based on an appropriate choice of RIT, and that if the result is considered unaffordable for general use, then consumers must expect to work longer and retire later in order to achieve an adequate retirement income.

More Efficient Decumulation Market

1. 7.11. Part of the problem with affordability lies in the inefficiencies of the individual DC market. We therefore suggest there is a need to find ways to harness bulk purchasing powers, along with the benefits of pooling investment and mortality risks. This would make DC pension provision more affordable and predictable for the consumer. The growth of master trusts should lend itself to the development of such solutions, as would the introduction of collective DC schemes.

2. 7.12. One aspect of particular concern is that the cost of individually purchased annuities is currently around 15–20% higher than the terms typically available to defined benefit pension schemes for bulk purchase under a buy-in or buy-out. This factor alone might reduce our calculated LPC down to around £430 per month, or the monthly equivalent of around 19.0% of AWE.

Low Interest Rates

1. 7.13. Low interest rates are a major reason for the current high cost of pension provision, and that is reflected in our RoT that the target pension at age 68 is 1.5 times the annual contribution. The impact of an increase in interest rates will depend on the timing of the increase and how it affects the investments, but as a rough indication an increase in long-term interest rates to 4% p.a. from the current (March 2019) level of around 2% p.a. might reduce the LPC by around 30%.

2. 7.14. Clearly nobody can predict the future level of interest rates, especially when we are looking ahead for 40 years or more. Many commentators believe we are in a new “norm” of low interest rates, so we should not rely on a reversion to the high rates experienced in the past.

3. 7.15. It should be noted though that we are still experiencing the effects of an unprecedented level of QE following the 2008 global financial crisis. Anticipating a modest rise in long-term interest rates on account of the unravelling of QE could be deemed reasonable when we are predicting what may happen in 40 years’ time and would have a significant impact.

Conclusions

1. 7.16. The issue of affordability is a serious one and requires widespread discussion. We believe the concept of the LPC can provide a useful platform for promoting such a debate, having regard to the various issues outlined in this section.

LPC

1. 8.2. We see merit in developing a single LPC, in order to create the maximum impact. Aimed primarily at young consumers, it would provide an early indication of the contribution needed for a reasonable retirement income, which can be refined at a later date once retirement plans start to emerge. Older consumers will wish to adopt a more tailored approach, but the LPC can still serve as a prompt if their contributions are below that level.

2. 8.3. The LPC would act as a benchmark of pension cost, increasing annually in line with AWE and adjusted periodically for other factors, such as interest rate changes.

3. 8.4. Promoting the LPC in the national media would help cement it in the general psyche.

4. 8.5. As discussed in section 7, the initial level of the LPC would need widespread debate to ensure it is appropriate and was not set at a level regarded as unrealistic by consumers or the financial press.

Potential Smartphone App

1. 8.6. While the LPC is a simple concept, the other RoTs we have developed involve some calculations. These calculations lend themselves to automation, e.g. via a smartphone app. Consumer acceptance of this app might be enhanced if it were developed and endorsed by an independent body.

2. 8.7. We appreciate that there are already many tools available to guide consumers with their retirement savings, and which offer a more tailored approach. The app we propose would aim to complement these tools, and in many cases would hopefully enthuse consumers to take a more personalised approach through one of these other tools.

Nudges

1. 8.8. RoTs will be more effective if used in conjunction with “nudges”, i.e. promoting actions at key “teachable” moments. An example is auto-escalation, where typically the percentage of earnings contributed increases automatically over time.

Market Research

1. 8.9. RoTs have the potential to influence general behaviour of both consumers and employers through clear and simple messages.

2. 8.10. We suggest that market research is undertaken to test whether the RoTs, including the LPC, would be helpful. The research can also address the means of communicating the RoTs, including the idea of a smartphone app.