Opinion: how to fix our broken pension system

The Government faces a huge challenge to fix our pension system. Here's what they need to do, writes Sarah Coles.

We’re reaching the end of a very long road for the introduction of automatic enrolment into workplace pensions.

The very largest firms were drawn into the system in 2012, and finally, in 2017, the last few small firms will become part of it.

In the intervening years the pensions landscape has changed dramatically, with more pension scheme members than ever before.

It sounds like an unqualified success, but it’s not. In fact, the way the Government has tackled auto enrolment has ensured millions of people will reach retirement without anything like enough savings.

It’s not fair to write off all that auto enrolment has achieved.

The system works by automatically signing employees up for a workplace pension scheme.

Within the pension, both they and their employer contribute a proportion of their salary each month.

They can opt out if they want to, but the power of inertia means that the vast majority don’t get around to it.

Government research in 2014 found that on average only 12% of people opted out, and as a result, participation in workplace pensions had increased from 44% to 76%.

This is a major breakthrough at a time when saving for your own retirement has never been more important.

Relying on the State Pension to keep you comfortable in retirement is a risky strategy at best.

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The problem we face

Already the Government is saying that the triple lock guaranteeing annual state pension rises cannot be promised beyond the end of the current parliament.

As we go further down the track, the picture gets even bleaker. The State Pension age for women is rising.

In 2018, when it reaches 65, the pension age for both men and women will then rise together, until it reaches 66 by 2020 - and 67 by 2028.

It will then continue to rise with longevity, so that today’s young workers will have to wait until their 70s for a State Pension.

But while increased occupational pension scheme membership is a step in the right direction, flaws in the system mean it’s not an unqualified success.

Many are excluded

One issue is the number of people who won’t be affected by auto enrolment.

The largest group of excluded people are those earning less than £10,000 – who are not automatically enrolled.

This threshold means that part-time workers are often excluded, along with the many people who cannot find full time work, so have taken on multiple part-time roles.

Those under the age of 22 are also excluded from the scheme. It means that, according to a Pensions Policy Institute study in 2014, there are 4.8 million employees who are not part of auto-enrolment, and don’t have any other pension provision.

The self-employed are also left out in the cold, as auto-enrolment does not extend to this group, and this is a booming sector of the workforce.

The level of self-employment in the UK increased from 3.8 million in 2008 to 4.6 million in 2015.

It is currently the fastest growing sector of the workforce, so over time even more people will miss out.

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How to fix our pension system (Image: Shutterstock)

Low contributions

Even where employees are brought into the auto-enrolment system, there’s the issue of contribution rates.

The Government has set minimum contributions laughably low: just 2% of salary goes into the scheme 1% from both the employer and the employee.

This is set to rise gradually over the next few years, but even when it hits its peak in 2019, it will only be 8% (5% from employees and 3% from employers).

The reasoning behind such low minimums, was to establish a level that wouldn’t scare employees when they saw the cash coming out of their pay packet.

The Government worried that if it set the level too high, people would feel the financial pain too keenly, and simply opt out.

There was always the concern that it would not leave people with large enough workplace pensions in retirement, but it hoped that employers would offer more than the bare minimum.

Unfortunately there’s little evidence of employer generosity in the market. In fact, we have seen a massive reduction in what employers are offering within defined contributions schemes.

The average paid into a defined contribution pension for workers in the most recent ONS study was 4%: 1.5% from workers and 2.5% from employers. This is down from 9.1% in 2013.

It’s partly due to the dilution effect of so many new members joining through auto enrolment on the statutory minimums, but is also partly because employers are choosing to ‘level down’ to provide all employees with the bare minimum.

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A further complication

To make matters worse, this contribution isn’t even paid on all of your salary. Currently contributions are not paid on the first £5,824 you earn.

Steve Webb, the former Pensions Minister and current director of policy at Royal London, has calculated that in order to fund a comfortable retirement with an 8% contribution, employees would need to pay into their pension every year from the age of 22 to the age of 77 - and take no time out to start a family.

He has called for the escalation to continue beyond 8% after 2019 - to at least double that level.

Webb has highlighted the fact that at the current contributions levels, we are still seeing an enormous savings gap between the sums required for a comfortable retirement, and the amount people are currently saving.

In fact, a study by Aegon last year found that just 7% of women and 10% of men are putting enough away and are on track for the retirement income they aspire to achieve.

The Government has pledged to review the auto enrolment system regularly, and is currently conducting one such review.

Many savers left short

Unfortunately, it made it clear from the outset that it won’t be considering contribution levels within the review – so a generation of savers will continue their long march to retirement poverty.

Dr Yvonne Braun, director of policy and protection at the Association of British Insurers, was disappointed, pointing out: “Increasing the contribution levels for automatic enrolment to 8%, due to happen by 2019, will still leave many savers without enough money for later life.

“This review should aim to take us much closer to agreement on how contribution rates should rise in the future.”

Instead the review is looking into eligibility criteria, and the 0.75% charge cap, so there is a chance that lower earners and the self-employed will begin to benefit.

There are also lessons the review could take from the international experiences of automatic enrolment.

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What other countries do

In Australia, for example, employees have what are known as superannuation funds, and since 1992 being a member of a ‘super’ has been mandatory for all those aged 17-70.

If the Government chose to make membership mandatory it would remove any concerns about higher contribution rates prompting people to opt out.

Alternatively, the Government could incentivise people to join.

This is the situation in New Zealand, where the Kiwisaver comes with a bonus payment from the Government as a reward for those who join a scheme.

It equates to over £500, which could help overcome any initial concerns about joining.

We know from experience, that once they are within the scheme, the vast majority of employees don’t get round to opting out.

The review could also look at the structure and level of contributions overseas.

In Norway, for example, employers have to make compulsory contributions to the workplace pension, but the employee does not have to match them.

Likewise in Australia employers contribute 9.5% of eligible salary (increasing gradually to 12% in 2019).

Employees don’t have to contribute anything, but they are encouraged to do so by a Government match at a rate of 50%.

If the UK was brave enough to establish both employee and employer contributions at this level, they could set every employee up with a comfortable retirement.

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A coherent approach

A better pensions system doesn’t start and finish with auto-enrolment, however.

While it forms a bedrock of workplace pension savings, this needs to be part of a coherent approach to pensions that has been conspicuous by its absence.

The Department for Work and Pensions is hard at work trying to persuade people to pay more into workplace and private pensions.

Meanwhile, the Treasury has been trying to cut the benefits of those pensions in order to save money.

Tom McPhail, head of Retirement Policy at Hargreaves Lansdown points out:

"The Treasury and the DWP are increasingly pulling in diametrically opposing directions.”

Damaging disconnect

Ros Altmann, former pensions minister, agrees that a disconnect between Government departments is highly damaging.

She says: "During my time as Pensions Minister, there was clearly a difference view between Treasury and DWP about private pensions.

“The Treasury sees them as a cost to the Exchequer. DWP sees them as a benefit for people to give them a better standard of living. That is how most people see them and why they are so important."

McPhail is calling for high-level discussions between the departments, where they can thrash out a single coherent strategy. This could meet the needs of both departments.

So, for example, at the moment, there’s a question mark hanging over pension tax relief, as Chancellor Philip Hammond is broadly expected to bring down the relief available in order to save the Government money.

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How to fix our pensions (Image: Shutterstock)

How to make things fairer

However, instead of axing relief, there is an opportunity to alter the way it works, to make it cheaper, fairer, and more attractive for basic rate taxpayers.

Currently when you pay into a pension you get relief at the same rate as the highest rate of tax you pay, which is why despite the fact that basic rate taxpayers make 50% of contributions, higher rate taxpayers get 70% of all the tax relief.

A flat rate, set above the basic rate would tip the balance in favour of lower earners, by essentially paying them to invest in a pension.

This would enable the Government to stop talking of ‘tax relief’ and position it as an incentive payment.

As McPhail says Tax relief is inefficient and poorly understood. The alternative of a 'Retirement Reward' set at a flat rate for all would be fairer, simpler and more effective."

There is also the opportunity to reign back on the restrictions on contributions to pensions. Reductions in the annual and lifetime allowance have been called ‘death by a thousand cuts’.

They have been widely condemned by advisers, who see more and more ordinary savers caught up in a tax nightmare in future, as growth in their pensions pushes them over the allowance and leaves them facing a tax bill.

Some kind of a reversal, or a commitment not to cut any further, would help demonstrate that the Government sees private pension savings as an asset rather than a cost.

Perhaps most of all, however, savers could benefit from a period of calm.

Sean McCann, personal finance specialist at NFU Mutual says: "Changes to pensions are likely to be bad news for long-term retirement savings.

“People need stability when it comes to their pensions and moving the goalposts - even just a little bit - could further erode people's faith in the system."

The best approach, may therefore to do as little as possible to pensions for as long as possible, until savers are confident that they won’t have the rug pulled from underneath them as they approach retirement.

Perhaps, therefore, the end of the gradual phasing in of auto enrolment could be used as a line in the sand.

This could be the end of the era of continual change, tinkering, disconnect and confusion, and the beginning of a time of stability.

The trouble is, of course, that with an imperfect system, and the opportunity to save money by cutting and trimming, there will always be the temptation to tinker.