Two recent surveys highlighted the predicament. One by BlackRock, of 25 to 34-year-olds, found that 31 per cent expect to retire on an annual income of £30,000 or more – a figure often cited by professionals as a reasonable ambition. But the same study also found that only 12 per cent were actively saving into a pension; instead 32 per cent were saving to buy a property, 27 per cent were saving to go on holiday and 10 per cent were eyeing up a new car.
A survey of 2,000 savers by Friends Life lent further weight: only 13 per cent were willing to contribute 10 per cent or more of their salary to a pension pot, while 61 per cent would opt out of a pension entirely rather than contribute 5 per cent of their salary.
Statistics like this can of course be misleading, but they do provide evidence of the widespread underfunding from the current workforce that drove political parties to launch pensions auto-enrolment in October. The cost of pensions, in real terms and in political credos, is a subject that has received much debate in Westminster in recent years, particularly surrounding reforms to generous public sector pensions.
And the ambition of auto-enrolment was to ensure that those at most risk of falling into poverty after retirement – and most likely to need state support – had at least some form of funded pension to top up standard state benefits.
But the problem is just as relevant for professional middle-income earners who are more likely to have, or seek, a relationship with an IFA. As the surveys illustrate, the vast majority are not saving enough into a pension to deliver the sort of retirement income they expect.
As we move into a post-RDR world where advisers are expected to give broad advice on their clients’ overall wealth rather than sell products, IFAs will need to question whether their clients can really afford any form of investing other than a pension.
This may sound a daft question given the array of tax-beneficial savings products available – ISAs, bonds and investment portfolios – but the problem with all forms of savings other than a pension is that the money is typically used to fund immediate spending rather than locked away to provide income after retirement. If clients are underfunding their pensions, how can they afford any other form of saving or investing?
To assess clients’ likely financial position upon retirement, IFAs must of course consider all information. Take the example of 35-year-old John, a hypothetical professional with the expectation of a £30,000 income in retirement, currently earning £60,000 a year. John is hardly part of the demographic targeted by auto-enrolment, but a cause for concern nonetheless. With 30 years to go until his retirement date of 65, is he on track?
Firstly advisers must estimate his likely ‘free’ state benefits. With reforms to state pensions planned but not yet implemented, this is a difficult task. Under the current rules, John could reasonably expect to receive the maximum allowed State Second Pension (S2P), providing an annual pension a little over £13,600 in today’s money. But if reforms to S2P go through, implementing a single-tier £140-a-week pension instead, this could be substantially less, falling in the worst case to £7,280.
Depending on the timetable and exact details of the reforms, John is likely to receive a mix of S2P benefits built up until the single-rate pension is introduced, likely some time after 2020. That could leave him with about 50 per cent of each, which – assuming the total pension receives a ‘triple-inflation guarantee’, rising each year in line with earnings growth, consumer price index or 2.5 per cent – John could expect to receive an annual state pension in the region of £10,400 in today’s terms.
Whatever happens, if John continues to be employed and pays his national insurance contributions, he can expect at least £10,000 ‘free’ from the government. That leaves him with £20,000 to make up. If, like the majority of the 24 to 34-year-olds surveyed by BlackRock, John has yet to start pension saving, he will certainly need to.
The next stage involves plenty more assumptions, a range of which is illustrated in Graph 1. But to keep things simple, let us take the central band of the new pension projection rates advisers must use from April 2014 onwards, of 5 per cent annual investment growth, and assume that a single-life level annuity in 2042 will yield 6 per cent (which until recently would have been reasonably conservative).
On those assumptions he would need to save £5,000 a year into a pension, or 8 per cent of his current £60,000 salary. But that ignores the impact of inflation. To maintain the purchasing power of his £30,000 objective in today’s terms, we should adjust John’s target. His £10,000 state pension will rise in line with inflation, but the additional £20,000-targeted income will in real terms rise to £36,227 assuming a modest 2 per cent annual inflation over the 30-year period. To hit that real income target, John must save at least £8,000 a year (13 per cent of his salary) until he is 65.
But we have omitted another crucial detail. While John hopes to retire at 65, the state pension age is likely to be at least 68, meaning he will have to wait three years or more to get his £10,000 a year from the government. He could make do for the first three years, or save a bit extra to provide him with a cushion and use the tax-free cash lump sum option.
If John had already started pension saving, he would of course be in a better position. But with most people uncomfortable locking away more than 10 per cent of their income, the scale of saving they need to make now to maintain their lifestyle in retirement can be eye-watering. For those who are drawn into auto-enrolment for the first time, the minimum 8 per cent annual contribution made jointly by the employee, employer and government will only take them part of the way forward.
It is not the job of IFAs to convince clients to do something they do not want. Immediate saving goals – such as tuition fees or house purchases – will always loom largest in the mind. It is all too easy to dismiss retirement as a distant prospect, with too many assumptions lying between then and now to plan with any precision. But IFAs looking wholeheartedly at their clients’ financial situations should not ignore the retirement funding gaps that are likely to be facing them. The only solution is to spend less now, save less to finance short-term projects and more to fund distant objectives. Ultimately, clients must decide, but IFAs should not shy away from illustrating to their clients their likely income in retirement rather than meaningless pension ‘pot’ sizes. If they do not, no one else will.
