How much pension contribution is enough?

Currently contributions into auto-enrolment schemes are 1 per cent, with the view that the majority of staff, particularly lower earners, will not miss out on 1 per cent of their salary each month - or at least not enough to be bothered to do anything about it and opt out of the pension scheme.

But the days of 1 per cent are over and the days of 5 per cent are almost upon most schemes, with 2019's 8 per cent total contribution rate hot on its heels.

The Department for Work and Pensions' (DWP's) 134-page report, Automatic Enrolment Review 2017: Maintaining the Momentum, acknowledges the need to build on the success so far of auto-enrolment and keep people saving into a pension scheme, no matter how high contributions rise.

Auto-enrolment has been successful in getting many more people saving more for the first time, but not necessarily saving adequately. Angie Kirkwood

In the foreword to the review, the former secretary of state for work and pensions, David Gauke, commented: "A key focus is for individuals to keep saving and to save more after minimum contributions reach 8 per cent in 2019.

"We stand ready to learn from the contribution rate increases which will come into effect in 2018 and 2019, and to carry out further work on the adequacy of retirement incomes."

Contribution rate rises

From April this year, employers must raise their contributions from 1 per cent to 2 per cent, and workers must raise it from 1 per cent to 3 per cent as a percentage of qualifying earnings.

This seems like a small step to take in terms of percentages, but in terms of real pound values, this could make a noticeable difference to a person's pay packet, especially considering how wage growth has been outstripped in recent years by inflation in the UK.

Research carried out in 2017 by Prudential revealed many young people - a core target group for auto-enrolment - simply do not have spare cash to save. 

More than 50 per cent of all those under 30 either make only the minimum contribution into their workplace scheme, or have no pension at all.

Yet it is mathematically clear that the amount people need to contribute depends on how long they have to save up before retirement. For example, a 25-year-old need only save approximately half as much as a 35-year old to end up with the same size retirement fund at 65, taking into account factors such as compounding of interest.

Table: Auto-enrolment contribution rate rises (Source: DWP)

To make sure people are not impoverished in retirement, creating the 2018 and 2019 auto-escalation of minimum contributions is a good start. 

"Auto-escalation is a very good way to harness the power of behavioural economics to increase pension contributions, and it works well in the US," notes former pensions minister Baroness Ros Altmann.

Associated changes

Alongside the contribution escalation is a trinity of concessions by the government on age and earnings.

In its review, it has pledged to reduce the lower age limit from 22 to 18 - which will simplify workplace assessment for employers significantly - and to remove the lower earnings limit to allow those earning less than £10,000 to opt-into a workplace auto-enrolment pension.

There will also be a change in the framework for auto-enrolment, so pension contributions will be calculated from the first pound earned, rather than from the lower earnings limit, which is set at £5,876.

"Removing the lower earnings limit simplifies messaging," the review stated. "Everyone earning over £10,000 and under £45,000 a year, who meet the other eligibility rules, would be automatically enrolled by their employer and get pension contributions on 8 per cent of all their earnings."

According to the DWP calculations, this will increase the pension pot of the lowest earnings by more than 80 per cent and that of the median earner by more than 40 per cent.

A 15 per cent contribution is a good starting point for a person in their 20s who is starting to save into a pension. Vince Smith-Hughes

Angie Kirkwood, senior policy manager for Scottish Widows, believes these are all good steps but more action should be taken. "The big questions are how [higher contributions] should be made up in terms of getting the right levels of employee contributions, employer contributions and tax relief, and the balance between the key intervention tools: engagement, defaults and compulsion."

But even with these changes, to bring more people within the scope of auto-enrolment and to escalate minimum rates in 2018 and 2019, there is a fear this might start to shake individuals out of their inertia and decide to opt-out.

This concern has been raised by the DWP, and in the review, it said it will monitor the impact of the phased increases in statutory minimum contributions.

How much is enough?

Regardless over concerns opt-out rates might rise commensurately with rising contribution levels, some believe even 8 per cent will not be enough.

This is the view of Ms Kirkwood, who states: "Auto-enrolment has been successful in getting many more people saving more for the first time, but not necessarily saving adequately.

"Saving 8 per cent of income a year will not provide a sufficient income replacement for most people. We're keen to support lower earnings being auto-enrolled with the accompanying right to employer's contributions."

Even the DWP's review conceded that point, stating: "We recognise contributions of 8 per cent are unlikely to give all individuals the retirement to which they aspire", and therefore will carry out "further work" on the adequacy of retirement income.

So how much should it be?

"The reality is 'enough' will depend on the individual's personal circumstances," says Chris Daems, director of Cervello Financial Planning. "Empowering individuals with the tools to work out what they need, their current financial situation and therefore the gap between the two would be a sensible start."

The tricky issue with pension contributions is increasing these enough so people prepare properly for later life, but not so much it feels too hefty a burden. Jon Greer

Ms Altmann believes there is "no actual rule that is the right or enough, but a good rule of thumb has always been that, if you have not yet started [to save], then a contribution level as a percentage of salary that is half your age".

Therefore, if you are in your 20s, roughly 10 per cent. (Think of Monica in 'Friends' - "10 per cent of your paycheck, always goes in the bank"). In your 30s, roughly 15 per cent, and 20 per cent for those aged 40.

Ms Altmann is not the only one to cite this rule of thumb. Adrian Boulding, head of retirement strategy for Dunstan Thomas, calls this 'Boulding's Law' (see box).

The DWP last year - have said 15 per cent is the contributory sweet spot. Yet contributions into workplace schemes - auto-enrolment or otherwise - fall short of this target.

In the ONS’s 2015 Occupational Pension Schemes Survey, the average employee member contribution in defined contribution (DC) schemes was revealed to be 1.5 per cent, with 2.5 per cent on average from employers.

Even career average schemes and defined benefit (DB) schemes have an average employee contribution of 5.5 per cent and 5 per cent respectively.

"A 15 per cent contribution is a good starting point for a person in their 20s who is starting to save into a pension," Vince Smith-Hughes, retirement income specialist at Prudential, agrees. "It sounds a lot, but the cost to the individual is reduced when you take tax relief and the employer's contribution into account."

Others think it could be less than 15 per cent. For example, in a video for FTAdviser, Julian Mund, chief executive of the Pensions and Lifetime Savings Association (PLSA), said the association calculated people seeking a long-term savings plan that would last for the whole of life after retirement should consider 12 per cent.

Ms Kirkwood agrees: "We believe the right level is around 12 per cent to provide an adequate income in retirement."

However Mr Mund said even this level of contribution could not be achieved immediately, but "step by step". 

An incremental approach might be the best way, says Mr Daems: "Certainly there would need to be a transitional period which brings people up to a level which will provide them with a sufficient pot."

This will avoid a cliff-edge scenario whereby people mass-default out of a scheme because contribution rates have risen too sharply and too swiftly.

Yet others might set the goal even lower, at 10 per cent, to avoid a rise in default rates. 

Jon Greer, head of retirement policy at Old Mutual Wealth, comments: "The tricky issue with pension contributions is increasing these enough so people prepare properly for later life, but not so much it feels too hefty a burden, and they end up ditching them altogether.

"While saving is important, there is a limit and people on lower salaries may find anything higher than 10 per cent a burden."

Barriers to further escalation

Ferdinand Lovett, associate director at Sackers, highlights an interesting point about the escalation of contributions above the statutory minimum. 

While employers are bound to the legal minimums, they are not as yet obligated by law to do anything more. For Mr Lovett, this could eventually create a situation whereby individual members are conscious of the need to save more but workplace schemes do not lift the contribution levels, effectively disbarring them from accumulating more for retirement through the auto-enrolment schemes.

Unless an employer places a high value on pension saving as a benefit to staff as part of the remuneration package, the UK could end up with some excellent auto-enrolment schemes at one end, and some basic, inflexible ones at the other by employers who see pensions as a cost.

He explains: "While I can see the constraints the government is under, in balancing costs imposed on businesses, ruling out any escalation would seem to bring a risk of taking the shine off the importance of auto-enrolment.

"It also risks leaving the more aspirational levels of contributions required to generate a good replacement retirement income to those employers who choose to invest in pensions, or to individuals who happen to realise it is worth saving."

Ms Altmann adds there is a huge educational gap to overcome, not just for employers but employees in understanding the benefits of increasing pension savings.

"It can help to ensure the pension [provided] includes access to financial planning and education, to help people think about their future needs.

"But this needs to be in plain English, without the complex jargon, which is something too few companies have been able to achieve," she adds.

simoney.kyriakou@ft.com