FD Capital Calls on Government to Increase Auto Enrolment Contributions and Allow Greater Pension Flexibility
FD Capital Calls on Government to Increase Auto Enrolment Contributions and Allow Greater Pension Flexibility
No one likes to think about old age, but your pension isn’t something you can afford to put off. For years, the state pension worked as a system because there were enough workers actively contributing to the economy and taxes to offset the cost of the programme. While the press has been focusing on the Triple Lock policy, the issue sits with the pay-as-you-go unfunded system. This structure isn’t viable long term as the population continues to age, while the birth rate declines.
While positive steps have been made, primarily through the auto-enrolment programme, there are still concerns about the future of pensions in the UK. The government has announced that the minimum age to take your pension will increase from 55 to 57 from April 2028. However, this policy will not impact those who retire early due to ill health.
At FD Capital, we believe the writing is already on the wall. We’re calling on the government to increase auto-enrolment contributions and to allow greater pension flexibility. These changes are required to transition the population to a more sustainable pension strategy, as the birth rate continues to decline and to ensure that retirees have the money they need to live comfortably in their old age.
The Financing of State Pensions
The UK state pension can be claimed from 66 years old. This age will rise to 67 by 2028. The DWP estimates that 80% of those reaching the state pension age will receive the ‘new state pension’ by the mid-2030s. The new state pension is currently worth £203.85 per week. This new state pension is at a higher level than the basic state pension at 30% of median full-time earnings.
State pensions are crucial for income distribution, particularly for poorer households. The state pension makes up over 70% of income for the poorest fifth households when someone aged between 66 and 70 is not in work. By comparison, it contributes 23% to the richest fifth of households in the same demographic.
The financing of state pensions has created one of the largest burdens on public expenditure. The government is expected to spend £152 billion, almost 6% of national income, on social security payments in 2023-24. Pension credit and winter fuel payment alone is £132 billion, the equivalent of 5.1% of national income. Most of the remaining expenditure on social security is spent on disability benefits and housing benefits, which are means-tested.
Challenges of Continuing with State Pensions
The challenges of continuing with the state pension revolve around the ageing population, which will add increasing pressure on the UK’s public finances in the future. The declining birth rate means that there are no new workers replacing retirees, creating a gap in tax revenue to pay for social security.
The Office of Budget Responsibility (OBR) says spending on winter fuel payments, pension credit, and state pension is expected to rise by 1.2% of national income (£32 billion per year) by 2050. Forecasting suggests there will be 25% more pensioners in 2050 than there are today. Another form of pressure is the need to reform health and social care in line with this population change. Spending on health and social care is expected to rise by 4.1% of national income, the equivalent of £105 billion per year, by 2050.
The ‘triple lock’ indexation policy was introduced in 2010 and increases the state pension annually by the highest of inflation, average earnings growth, and 2.5%. It means that the value and spending on the state pension significantly increases annually, creating a level of uncertainty for public finances. Instead of increasing the state pension equivalent to average earnings, the triple lock could add an additional £5 to £40 billion annually to the cost of pensions in 2050.
Although the new state pension is meant to be simplified, it continues to confuse people and has led to widespread pessimism. Almost 40% of people believe that the state pension will not rise in line with inflation in the next 10 years, even though it has since 1975. 30% of people do not believe that the state pension will still exist in 30 years.
The Current State of DC Pensions in the UK
Defined contribution (DC) pensions allow individuals to develop their pension fund through investment returns, tax relief, and contributions. Before April 2015, most DC pension holders used it to purchase an annuity. The pension legislation at the time strongly encouraged this, authorising a lump sum or flexible pension payments in certain circumstances.
In the 2014 budget, the Coalition Government announced that those with a DC pension could make withdrawals how they want, subject to their marginal rate of income tax. The government launched a consultation the following year to assess how individuals were accessing their pension flexibilities and how it could be done at a more reasonable cost. As part of the review, the Government announced proposals for making the process around flexible pensions smoother and more efficient. The government put a duty on the FCA to impose a cap on charges for early exit and withdrawal from pensions.
Current Flexibility with Pensions in the UK
The so-called pension freedom tax rules allow those with defined contribution pensions to access their savings earlier, so long as they have reached the minimum pension age, which currently sits at 55 years old. Currently, early retirees can choose to take their pension as:
- The full value in one payment
- Several payments a year for a shorter period
- One or multiple payments annually for multiple years
With life expectancy on the rise and the cost of living increasing, there is a need to question how those taking their pension early at 55 can support themselves in old age. Many of those who take their pension at 55 will return to work in another role or have additional income.
The Need to Evolve from the State Pension
The state pension and the National Health Service began when the population looked very different. The widespread pessimism around the state pension and its future reflects the awareness that our population is changing. There’s also concern about the lack of knowledge and awareness of the state pension.
- Only 20% of working-age people have any idea, even an approximate cost, of how much a full state pension is worth.
- Almost 40% believe the state pension will rise by less than inflation over the next decade, even though it has risen at least by the level of inflation since 1975.
- 30% of people do not believe that the state pension will still exist in 30 years, which may be a contributing factor to the over 40% of people who do not believe they’ll enjoy a quality standard of living when they retire.
The UK’s ageing population will continue to add additional pressure on public finances going forward, especially as the birth rate continues to decrease. Pressures on health and social care budgets, the triple-lock indexation method, and spending on pension credit, winter fuel payment, and the state pension are unsustainable for the future.
The health and social care budgets alone are expected to rise from 9.5% to 13.6% of the national income by 2050. The need to provide care for an increasingly older population will be a driving factor in this additional spending.
Today’s government has to prepare for tomorrow’s population, even with the uncertainty around what that might look like. The ageing population presents an existential crisis for public finances.
The triple lock means that there is an in-built annual increase for public spending, relative to inflation and average earnings. There has been discussion around the triple lock and whether abandoning it, or increasing the state pension age, is the only way to control future spending, while ensuring that there is a near-universal and flat-rate state pension.
However, shifting the focus away from the state pension and towards programs like auto-enrolment contributions can address this problem. Increasing auto-enrolment contributions and adding more flexibility to pension funds means the government may one day be able to move away from the state pension and ensure that retirees have a good quality of life in old age.
Auto-Enrolment Contribution Should Be Increased
The auto-enrolment initiative was launched by the government in 2012. It requires every UK employer to automatically put their qualifying staff, those aged between 22 and the state pension age, who work in the UK and earn over £10,000, into a workplace pension scheme. Both the employer and employee contribute to this scheme.
However, employees can opt out of the workplace pension scheme, but only for a short window of time. Companies are not allowed to actively encourage their employees to opt out of workplace pension schemes. The decision to opt out of it must be taken entirely independently by the employees.
Employees who have been automatically enrolled into a pension scheme have one calendar month to opt-out and receive a full refund for any contributions made so far. This short opt-out period starts from either the date of active membership or when the employee receives a letter from their employer with enrolment information.
Staff cannot opt out of the auto-enrolment scheme until the opt-out period starts or after it ends. If they leave the scheme beyond this period, they’ll be ceasing their active membership in the workplace pension scheme and not all of these schemes will allow for contributions to be refunded.
Current data shows that almost 80% of employees, an estimated 22.6 million people, are actively contributing to a workplace pension. This is almost a 50% increase to those using a workplace pension scheme before the introduction of the auto-enrolment scheme. It’s a significant step forward and shows that change is possible with proactive schemes such as this.
Now that a significant proportion of the working population is contributing to a workplace pension scheme, it’s time to shift their focus from getting them to save to ensuring they have enough in their pension fund.
Auto-enrolment has been a major success with 5% employee and 3% employer contribution. This 5% is split between 4% directly from the employee and 1% from the government. However, this percentage is far too small and only applies to a certain level of earners. Auto-enrolment does not include self-employed individuals and employees can opt out.
FD Capital is calling on the government to raise this percentage to 16% with a 6% employer contribution, a 8% employee contribution, and a 2% government contribution.
Actuaries are recommending this level of contribution, but across the board for all earnings. A change of this nature would need to be introduced in phases with employers given time to prepare. This transition could be spread between 4 to 5 tax years to make it manageable for companies.
There is an increasing amount of research showing that one of the major priorities going forward is ensuring that people are saving enough for their retirement. The current cost of living crisis is no doubt contributing to these concerns, particularly that retirees may face poverty in old age as a result of insufficient support and not saving enough.
Most people with a defined contribution pension will not currently save the amount of money they expect to have when they retire. Almost 70% of people face a gap between their likely pension pot and the income they expect to have by more than £100,000.
Adding More Flexibility for How Pensions Could Be Used
Identifying ways to make pension funds more flexible can help the government move away from state pensions. For example, being able to take out a mortgage on a property with the same commercial rate but directing the interest rate to a retirement fund, instead of to a bank. It would create a better return and provide an additional contribution stream for pensions.
A programme like this would require regulation, as it cannot be treated like a traditional mortgage. Such rules would likely include a limit on the percentage of the pension fund that could be used for a mortgage, capped at 50% or less.
Ensuring Better Quality of Life for Pensioners
Increasing auto-enrolment contributions and allowing for flexibility would ensure pensioners have a higher quality of life after retirement. Transitioning to a focus on auto-enrolment and employer/employee contributions would meet the needs of our ageing population without creating further burdens for public spending.
Adrian Lawrence FCA with over 25 years of experience as a finance leader and a Chartered Accountant, BSc graduate from Queen Mary College, University of London.
I help my clients achieve their growth and success goals by delivering value and results in areas such as Financial Modelling, Finance Raising, M&A, Due Diligence, cash flow management, and reporting. I am passionate about supporting SMEs and entrepreneurs with reliable and professional Chief Financial Officer or Finance Director services.
