Posted on January 27, 2017 by Tom Tyson
Have you been ‘nudged’ into a workplace pension? Feel up to speed with changes to the state pension? Confident you’ll have a comfortable retirement? Worried there’ll be more changes – to your pension schemes and/or pension age? Do you understand who does what in the world of pensions? With pension reforms shifting responsibility for retirement planning to individuals and away from the state, to provide clarity, we’ve just launched a Pensions Landscape site to explain who does what in this complex landscape and the key challenges facing the government.
So what does all this mean for individuals? Drawing on some of our recent reports, detailed on our new Pensions page, I’ve outlined in this blog-post the types of pensions, the reforms to the system and challenges government and individuals face, help available for the new financial decisions people need to make, and protection mechanisms in this key sector.
State pension reform
Most of us will get a pension from two sources: the state pension and a private pension – a workplace pension and/or a personal or stakeholder pension. However, financial pressures on the state pension are mounting. The state pension and other pensioner benefits cost the public purse £117 billion in 2015-16, and this amount is growing as we live longer and the proportion of retirees in the population rises. Successive governments have had to consider the longer-term financial implications and the balance between state and private pensions.
In Introduction of the new state pension we found that, under the new arrangements, by 2060 the cost of state pension expenditure is forecast to be 0.5% of GDP lower than it would have been under the old system. The new state pension shifts the balance away from the state to the individual: the Department for Work and Pensions (DWP) expects 76% of people will be worse off than they would have been under the old state pension. This is largely because individuals will no longer accrue pension rights through an earnings-related state second pension.
Increases to the state pension age are also reducing government spending on the state pension. The pension age is gradually being equalised for men and women and will rise to 67 by March 2028 for everyone.
Although in the future many individuals will get less from the new state pension, the changes aim to make it simpler and fairer. Everyone will build up their state pension in the same way; a flat rate accrual based on the qualifying years of National Insurance contributions. The government hopes this greater simplicity allows individuals to find out what they will get from the state at a younger age and plan what other savings they need to support themselves in retirement.
Private Pensions – nudged into a comfortable retirement?
In an attempt to ‘nudge’ people into saving more for their retirement, automatic enrolment was introduced in 2012. It’s now compulsory for most employers to automatically enrol their eligible workers into a pension scheme and for the employer to pay money into the scheme. As expected, inertia and disengagement mean 6.9 million people are now saving or saving more in a workplace pension as a result. Total saving into workplace pensions has increased by £7 billion since 2012, and is forecast to rise to £17 billion by 2019-20.
But questions remain. Are people saving enough? How does this vary across the population? And the same inertia that automatic enrolment relies on may mean that people don’t make the effort to understand their pensions. For example, what type of pension it is? What are the tax consequences of their pensions? And are they contributing enough?
Types of pension:
Around 95% of people enrolled under automatic enrolment are in Defined Contribution (DC) pensions. Under DC schemes, pension contributions are invested in funds that build up entitlement to a pension pot. This offers no guaranteed retirement income, but instead gives members a pot of money that they can spend in retirement. This is in contrast to Defined Benefit (DB) pensions, which used to dominate the pensions landscape. DB pensions offered members a guaranteed retirement income based on a pre-determined proportion of the employee’s earnings.
The government needs to ensure that people understand the different risks associated with DC schemes. Low default contributions levels, and potentially conservative investment strategies will lead to low pension pots at retirement unless the government succeeds in getting people to engage with their pensions.
UK private pensions operate under an EET system: contributions are exempt from tax (E), investment income is exempt from tax (E), but pension income is still subject to tax (T). This system is seen to incentivise saving but it also cost government up to £35 billion in 2014/15 in lost tax revenue. The government needs to weigh the pros and cons of pension tax relief, including the extent to which they encourage people to save more and who is incentivised. Successive governments have cut back the relief available to those on the highest incomes.
It’s particularly important that people understand the level of contributions they are paying through automatic enrolment. The Work & Pensions Select Committee has suggested the default rate of 8% (4% from the employee and 3% from the employer, with 1% tax relief) will leave many with inadequate pension pots. An engaged saver can remedy this by increasing their own contributions or making alternative arrangements. But many people may not realise the shortfall until it’s too late to make it up.
Pension freedoms: free to make mistakes?
At retirement, individuals now face one of the most complicated financial decisions of their life. The introduction of ‘pension freedoms’ increases choice, but they also make the decisions more complicated. There is no default position to fall back on. People have to engage with the issue and work out their best option. They have to consider, among other things: how long might they live? Do they want cash or income? What are the tax and inheritance implications?
The shift to DC schemes means more people are building up a pot of money rather than a guaranteed income at retirement. Previously, most people were limited in their choice as to how they spent that pot of money and 75% purchased an annuity, a product that guarantees a retirement income. Pension freedoms reward those who have saved into DC pensions by allowing them freedom and choice as to how they spend that money. The requirement to purchase an annuity has been abolished. People can access their money however they wish, including taking it all as one lump sum.
Much has been made of the dangers of people ‘blowing’ all their savings by cashing out and purchasing luxury goods, leaving them with nothing but the state pension to rely on in later years. For many, cash conversions may make sound financial sense. However, the government wants people to recognise that purchasing an annuity will remain the most appropriate choice for many, as a way of compensating for lower state pension incomes.
Navigating this complex landscape
The government has created a system that requires people’s understanding and informed decision-making through their working lives and at retirement; individuals now have much greater responsibility for their own retirement planning. However, this places extra onus on the government to create an architecture that supports people saving into workplace pensions and making informed decisions throughout their working lives and at retirement.
Explore our new interactive Pensions Landscape site to find out who does what, to understand the types of pension and learn about the government’s reforms.
People need support with financial decisions
Most people will need guidance about the increased choices at retirement. Pension Wise was created to guarantee everyone with a DC scheme access to free and impartial guidance. Delivery of the service is provided by The Pension Advisory Service (TPAS) and Citizens Advice. However, there’s no requirement to seek guidance and the Work and Pensions Select Committee stated that usage of Pension Wise has been disappointing so far. The government has announced its intention to create a single public financial guidance body. This would replace TPAS and the Money Advice Service, which are the two main bodies currently offering advice on pensions.
People may choose to take advice from independent financial advisors. However, increased demand may put upward pressure on prices. If people elect not to take any guidance or advice, they could be exposed to potential rip offs and scams, and it’s likely that new and sophisticated investment scams will emerge. DWP, the regulators and advisory bodies are working to raise awareness of such scams. (See also our blog-post: Do you feel protected as a consumer?)
Effective and coordinated regulation will be needed to protect consumers
An appropriate regulatory regime is vital to the success of the system, regardless of whether individuals are engaged with their pensions. Regulation is split between The Pensions Regulator and the Financial Conduct Authority, with the Prudential Regulation Authority also playing a role. As the pensions landscape changes and with the introduction of government reforms, the demands on these bodies are changing. Together, they need to be have sufficient oversight to ensure that individuals are protected against the risk of pension mis-selling.
The rise of master trusts with automatic enrolment is also changing regulatory requirements. Master trusts are trust-based schemes that serve multiple employers, whereas traditional trust-based schemes were for a single employer. TPR has voiced concerns over their lack of regulatory authority in this area. A Pensions Bill is going through Parliament that seeks to strengthen regulatory requirements for master trusts.
The direction of travel on pensions is clear; a flat-rate state pension to be supported by adequate levels of private pension saving. The government is well aware of the challenge it faces to get people to engage in a meaningful way with their pension savings. Greater flexibility at retirement through pension freedoms has helped spike interest, yet the complexity of the choice facing consumers underlines the importance of making reliable advice available. And across the landscape, consumers need to be able to have faith in the regulatory environment to protect them against mis-selling and scams.
We hope you find our pensions website helpful and welcome your comments on this blog-post. Please also contact us to discuss any of the issues raised in our pensions work.
About the author: Tom Tyson is an Audit Principal at the NAO. He has worked on several studies around the Department for Work and Pensions’ implementation of pension reforms and wrote his dissertation on the impact of automatic enrolment on UK pensions policy.
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