Every employee dreams of the day they can retire and enjoy some of their aspirations, be it travelling the world, spoiling their grandchildren or moving to their dream home.
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- The minimum 8% contribution required under auto-enrolment legislation will provide employees with a decent income in retirement if they start saving at age 22.
- Employees should aim to contribute a percentage of salary equivalent to half their age when they begin contributing, or aim for a pension fund equal to the value of their house.
- The workplace is a trusted place for staff to be educated about retirement saving.
But for an increasing number of employees, such dreams will remain exactly that. A squeeze on household budgets, low or no pay increases and a failure to realise that the state alone will not pay for their retirement, together with a general lack of pensions knowledge, means that retirement will look very different for many employees.
The move to a primarily defined contribution (DC) pensions environment may also have played a role in this bleak outlook, says Damien Stancombe, head of employee benefits at Barnett Waddingham.
“The DC vehicle was never designed to be a primary pension scheme deliverer in terms of pension income,” he says. “It was designed as a top-up to a strong state scheme, or it was designed as a top-up to a defined benefit [DB] environment.
“Therefore, the shortcoming of a DC scheme is the amount of money that we, as the individual and employer, have to contribute to get a good outcome. Whichever way you go about it, that is the fundamental problem with DC.”
The average value of a DC pension fund that is used to buy an annuity is currently less than £30,000. This assumes average pension contribution rates totalling about 8.9%.
Helen Powell, senior professional support lawyer (pensions) at law firm Allen and Overy, says that at today’s rates, this would buy a 65-year-old a single life pension (with no increases or guarantees) of around £1,838 a year. To secure a more comfortable standard of living in retirement, an employee would require a pension pot of about £430,000.
According to the Office for National Statistics’ (ONS) report Pension trends, chapter eight: Pension contributions, 2013 edition, published in July 2013, the average employee contribution rate to DC schemes in 2011 was 2.8% of salary.
So how much do employees need to contribute to a DC pension to achieve a decent level of income in retirement?
Martin Freeman, director at JLT, says: “It’s going to depend on various factors: how much employees actually want in retirement, their current earnings, how much the state pension is making up of that, and what degree of risk they are happy to accept.
“One of the interesting things is that it’s not just a question of if they contribute X, they will get this [level of income]. It’s if they contribute this, they will have a 50% chance of getting to where they want to be, or better.”
One common rule-of-thumb with which employees can determine adequate contribution rates is a total pension contribution equal to half their age when they begin contributing to a scheme.
John Reeve, senior consultant at Premier, says: “That fits quite well for employees on average, or slightly above-average, salaries, although the idea of a 40-year-old putting in 20% of their salary is not especially likely. But for staff in their 30s and 40s, it works quite well as a target.”
But the contribution burden does not rest solely with employees. James Biggs, head of corporate pensions at Lorica Employee Benefits, says: “When we talk about affordability, we say there are three approaches to it. Number one: the employee pays in 5% to 7%, assuming their employer is putting in a similar sum.
“Number two: there’s the actuarial adage, which is half their age as a percentage of salary. A mid-teens number is a good one because the typical average age of an employee in a pension scheme at the moment is mid-30s, but when you take auto-enrolment into account, it’s probably going to come down to early 30s or late 20s, so a mid-teens number ties in with this.
“The third criterion for what members should pay in is as much as they can afford towards their target, as long as they revisit it if it isn’t enough. So, they should not worry if they can’t get to that mid-teens number now, but they should be aware of where it will get them to and that it’s worth revisiting.”
Reeve says employees could also aim to build up a pension pot equivalent to the value of their house, to help focus their mind on adequate contribution levels.
Whatever criteria employers use, the suggested contribution levels for staff to obtain a comfortable income in retirement are significantly lower than the minimum 8% required under auto-enrolment legislation.
A report published by the Pensions Policy Institute (PPI) in October 2013, What level of pension contribution is needed to obtain an adequate retirement income? found that the probability of an employee, who contributes the minimum 8% of band earnings, starts to save at age 22, retires at the state pension age and follows a traditional investment approach, achieving their target income replacement varies by earnings level.
It found that lower earners (those considered to earn at the 30th percentile of economy-wide, age-specific earning levels at each year they are in work) have a 63% probability of achieving their target retirement income. Median earners (at the 50th percentile) have a 49% chance and higher earners (at the 70th percentile) have a 40% chance.
For many employees, the fact that they have been auto-enrolled at a minimum contribution level set by the government may be enough to reassure them that this will provide a sufficient retirement income.
But Philip Smith, head of defined contribution and wealth at Buck Consultants, says: “Based on the calculations we made when auto-enrolment was introduced, and taking into account the new level of state pensions at £144 a week, we think employees need to pay about double the auto-enrolment minimum contributions to get a reasonable standard of living in retirement. Even the most sophisticated employees are quite shocked when they find just how expensive it is to provide a retirement income.”
Chris Curry, director of the Pensions Policy Institute, adds: “Our research highlighted that auto-enrolment is a very good starting place for increasing the number of people saving into a workplace pension, which it seems to be doing very well at the moment. It will mean many more people will be taking the first steps towards having an adequate retirement income.
“But it also highlighted that employees need to do more than just take that first step. Even if someone is a median earner and contributes from age 22 to age 68, is continuously in work and contributing throughout that time, even under our most optimistic assumptions, they still only have a 50-50 chance of having a retirement income that means they don’t see a big fall in their living standards when they stop working.
”I don’t think there are many people who are happy about having a 50-50 chance of achieving something. They’d much rather get much closer to being certain.”
Education and communication
Workplace education and communication are key to ensuring staff are aware of the need to contribute more. However, a mistrust of pensions and other, often more immediate, financial priorities means it can be hard for employers to engage staff with the need to make adequate retirement provision.
It is vital to use clear, simple communications that employees can understand easily, and messages that they can relate to their own circumstances.
Buck Consultants’ Smith says: “I don’t think putting broadbrush, unpersonalised websites up with the kind of typical generic modellers that have historically been used is necessarily the best thing. It’s pretty hard to get employees to log on to websites and think of this proactively, so employers need to think of some real targeted communications on a personal level, spelling out to employees exactly where they are heading.”
Using imagery, rather than reams of text, and steering clear of technical language and jargon can also go a long way towards engaging staff with pension contributions and help them to understand the long-term impact of their choices. For example, rather than referring to percentage contributions, employers could translate these into pounds and pence.
Premier’s Reeve says: “If employers tell their employees: ‘you’ve got to save 12% of your salary into an equity-based return in order to buy an annuity at the end of it’, they will just switch off immediately because there are three terms in there that most people don’t understand.”
Employers should also encourage staff to consider their savings needs more holistically, in terms of short-, medium- and long-term priorities, says Barnett Waddingham’s Stancombe.
“If we look at pensions in isolation, it is like looking at a game of football and just looking at the goals,” he says. “We lose everything else that is happening, and what is happening now is far more important than an event 40 years down the line. So savings has to become what we are educating people about, not just pensions.
“The education piece will make it valued. If employees value it, they will contribute more and it becomes an aspirational thing and they will save for a decent outcome.”
Case study: Molson Coors Brewing Company seeks pensions understanding
Molson Coors Brewing Company is taking steps to help its employees understand their pension fund and voluntarily increase their own contributions.
It relaunched its group personal pension (GPP) scheme in July 2013 with a new provider, to comply with auto-enrolment legislation ahead of its August 2013 staging date. Its employees are auto-enrolled on a minimum 3% contribution, although they are encouraged to increase this voluntarily to at least 5%. The organisation matches contributions up to a maximum of 8%.
Oliver Polson, pensions manager, UK and Ireland, at Molson Coors, says: “We don’t force employees because we’re conscious of not wanting to scare them off. Our view is, especially with the younger staff, that it’s much better to get them in [to the scheme] and gradually get them to increase their contributions rather than them being knocked out straight away and never being engaged.”
To boost staff understanding around pension contributions and what these mean for their retirement funds, Molson Coors offers an online modelling tool to demonstrate the impact of different contribution levels. It also intends to launch a communications campaign to help staff understand their annual pension statements.
Polson says the organisation will also target specific sections of its workforce with future communications. “We are going to do a targeted campaign for younger employees around pay review time on the impact of increasing their contributions by just 1%,” he says.
The organisation has also carefully considered the language that will be used in this. “Rather than talking in percentage terms, we are going to talk in pound terms because some feedback we’ve had is that staff don’t listen if we talk about percentages,” says Polson. “They just think about their net pay packet. We’re trying to make it more real to them.”
Molson Coors actively monitors its employees’ contribution levels and has already seen a 10% rise in the proportion of scheme members who are paying in the maximum matched contribution levels or above.
It has set a target to increase the proportion of staff contributing at least 5% by 10% over the next year.
Viewpoint: Helen Powell: Employer’s role in improving member outcomes by design
The defined contribution (DC) pension affordability gap means many employees may not be able to afford to retire at the age they would prefer. With no UK default retirement age, promotion opportunities and succession could grind to a halt.
So what can, or must, employers do in response to the mounting DC crisis, to give employees the best chance of achieving a reasonable income in retirement?
Historically, employers have not been legally required to provide for, or even take much interest in, members’ DC outcomes beyond providing access to a stakeholder scheme, although, of course, many employers do much more than this. However, DC regulation is evolving quickly, particularly in relation to contributions and scheme design.
The auto-enrolment regime requires employers to make pension contributions on behalf of each employee enrolled, but this is not a complete answer to the DC gap. Even when the regime is fully in force from October 2018, the minimum requirement will be less than the current average contribution rate.
Many employers are considering ‘smart’ strategies for increasing contributions to a more appropriate level, such as auto-escalation (whereby staff agree in advance that, at a particular date or salary level, they will increase the percentage they pay in) and matched or incentivised contributions.
Employers must also work with trustees and providers to ensure contributions are paid to the scheme correctly and on time, and must comply with information and record-keeping duties.
The Pensions Regulator has provided guidance on what employers should look for when selecting a scheme for auto-enrolment. Charges can dramatically reduce a member’s retirement savings, so the government intends to introduce caps on default fund charges.
The vast majority of members use default funds rather than making active investment choices, so it is vital to get the design of these strategies right. The government also plans to introduce minimum standards for default fund design and governance.
Whatever new or existing scheme an employer uses, it must provide value for money, comparing the charges deducted from members’ DC pots with the quality of the overall product.
The regulator is also encouraging employers participating in either a group personal pension or a master trust arrangement to take a more active governance role by introducing employer management committees.
Key elements of good DC outcomes hinge on member choice, so encouraging member engagement is vital. Increasingly, employers are supporting innovative communication campaigns to highlight the importance of saving for retirement and choosing appropriate investment options.
Employers are sometimes wary of appearing to give financial advice and may find the regulator’s guidance on what should, can and cannot be said about pensions a useful resource.
The battle is on to improve member outcomes by improving DC structures, through encouragement and best practice, and by force, if necessary, through the imposition of minimum standards.
Employers have an important role to play, which, in the longer term, they cannot afford to ignore.
Helen Powell is senior professional support lawyer (pensions) at Allen and Overy