No magic formula for pension savings

By using the client’s current age, say 40, and then dividing by two, so 20, that was the percentage of their annual income they should save/contribute each year – so 20 per cent in this example, to achieve an ‘adequate’ retirement income.

The basis for this calculation was to contribute a sufficient amount that would secure a pension equivalent to two-thirds of expected final earnings. This is the amount someone could expect to get after 40 years’ service in an average final salary, defined benefit scheme.

For many people this was, and still is, a scary and, for some, a totally unrealistic figure for them to commit to save. But the simple formula did provide people with some rough guidance on the cost of trying to achieve an acceptable or realistic level of income in retirement, and importantly, whether they were on track.

However, since then UK pension savings have not been helped by a real lack of consumer confidence in the private pensions system.

There are lots of people who are not making any savings into a pension to secure an income in their retirement, and auto-enrolment is playing a huge role in getting more people started on the pension savings ladder. But the big question is still whether we are saving enough for a comfortable retirement.

A very timely report by the department for work and pensions published this August entitled Scenario Analysis of Future Pension Incomes, considers the subject of adequate savings for retirement.

The report takes into account the future impact of the new single-tier state pension and the impact of automatic enrolment reforms, which should ensure more people are on track for a decent retirement income.

The report is extremely useful, as it includes an analysis of current pension savers and identifies the number of under-savers, which are then broken down into five groups.

Under-saving is measured by ‘pensions adequacy’, which is a ratio of a person’s average pension income over his retirement, compared with his average earnings between 50 and the state pension age. In other words, a replacement rate.

Using this measure, the DWP has estimated that around 11.9m consumers who are below the state pension age are not saving enough for an adequate income in retirement. It provided an analysis that broke these people down between the five groups or bands.

For example, band 1 represents consumers with earnings of under £12,300 a year, who in many cases will be reliant on the state pension for the bulk of their income in retirement. The report shows that 0.2m of consumers in this income band are under-savers (as measured by pensions adequacy), which represents only 7 per cent of all the consumers in band 1 and is only 1 per cent of all under-savers.

The largest groups of under-savers are those in the moderate to higher earner bands 3 and 4, with incomes of between £22,700 to £32,500 and £32,500 to £52,000 respectively.

Between them, these two groups comprise 8.8m or 73 per cent of the total of 11.9m under-savers. And while the wealthiest band 5 (those with earnings over £52,000) has only 1.1m under-savers that equates to 67 per cent of the consumers within that band, which is higher than any other band. So the general trend is the wealthier you are, the more likely you are not saving enough for retirement.

Having analysed the number of individuals that are under-saving in each group, the DWP report then looked at the depth of this under-saving. In other words, how far are these under-savers away from achieving their target retirement income?

For example, table 2 shows there are 1m ‘substantial under-savers’ – people who are on course to achieve less than 50 per cent of their target retirement income. Interestingly, these people only represent 8 per cent of all under-savers, whereas the ‘mild under-savers’, that is those who are on course to achieve more than 80 per cent of their target income, represent 49 per cent of all under-savers.

So with the new reforms in place, the DWP believes that around 92 per cent of under-savers – those who are consider to be mild or moderate under-savers – will be on track to secure an adequate income in retirement.

The DWP points out that some of these consumers, mainly in the low-income bands, need only a few extra pounds in retirement income to achieve a pension that is at an adequate level.

This is because in many cases the state benefits will still be the primary source of income for the 92 per cent of under-savers in the UK. For example, in band 1 they estimate that 78 per cent of total pension entitlement will be provided by the state.

So the conclusion is that while there are many that need to take action with their savings, it is really the moderate and high earners who are most in danger of falling short of their retirement expectations.

This is a very interesting and valuable report by the DWP which paints a very positive picture for the future, mainly due to the huge contribution that auto-enrolment has played and will continue to play in encouraging consumers to save for their retirement. And while there may be a multitude of other conclusions that can be drawn from this report, perhaps the key question, which is not in the scope of the report, is what impact the Treasury’s new Freedom and Choice reforms that come into effect in April next year will have on pensions adequacy.

Given consumers will be able to take their defined contribution pension pot as cash, the funds required to secure their pension income may instead be used to pay off debt or fund a holiday.

In the US and Australia the freedom to take the pension cash already exists, and in both these countries there is a grave concern that consumers are outliving their private pensions.

According to the US Employee Benefit Research Institute, 43.3 per cent of US baby boomers, (those in their late 50s or 60s) will probably run out of money in their retirement.

This is because the savings are often inadequate in the first place, and in retirement people spend their funds rather than use some or all of them to secure a lifetime income stream.

So while the DWP’s forecast for future retirement income is very encouraging, in this ‘new world’ from next April, the amount of savings someone has is but one issue.

How those savings can best be used effectively over the next 25 or so years in retirement is a completely different challenge. This is where advice and the opportunity to use the ‘guidance’ guarantee will be so crucial.

So there is really no magic instantaneous formula to determine how much an individual should save and how those savings should be employed during their retirement years.

Everyone will have different aspirations, different ways of funding their retirement income and different needs in retirement.

It will only be through individual analysis of people’s personal circumstances that an adequate or hopefully comfortable income in retirement may be achieved.

Tim Gosden is head of strategy for individual retirement solutions in Legal & General’s retirement business

Key Points

* There are lots of people who are not making any savings into a pension to secure an income in their retirement

* The largest groups of under-savers are those that are in the moderate to higher earner bands with incomes of between £32,000 to £52,000 and over £52,000

* The key question is how the Treasury’s new ‘Freedom and Choice’ reforms that come into effect in April next year will impact ‘pensions adequacy

.