Eight per cent of what?

Employers and the Government need to be clear about how much pension personal accounts will actually deliver. John Greenwood investigates

The Department for Work and Pensions has got some new statistics together on how well savers in personal accounts will do after a lifetime saving in the scheme.

The data confirms what we already suspected, that most of those saving in the scheme from the age of 22 to 68 will see reasonable improvements in their retirement income.

But the figures also remind us of just how low the incomes of the target market are, which is why loose talk of ‘putting away 8 per cent of earnings’ must be nipped in the bud.

The DWP says that almost two-thirds of people who are not currently saving for their retirement but will be automatically enrolled into a workplace pension scheme from 2012 are earning below £20,000. Nearly one in five are earning below £10,000.

Watson Wyatt points out that the fact that so many below average earners are affected means contribution rates as a percentage of gross income will typically be far lower than the headline figure of 8 per cent.

Qualifying earnings are based on income between £5,035 and £33,540, so the 8 per cent minimum contribution will never be more than 6.8 per cent of gross earnings. DWP figures show the median income of relevant employees was just £17,000 in April 2007, with 19 per cent earning less than £10,000. For around half of those auto-enrolled, the statutory minimum employer contribution will be 2.1 per cent of gross earnings or less.

Paul Macro, a senior consultant at Watson Wyatt, says: “The way the system has been designed makes it important not to exaggerate how much money will be going into people’s pensions. It is dangerous to slip into a shorthand way of speaking and say that 8 per cent will be paid into employees’ pensions. The real question is: 8 per cent of what? Typically, the minimum contribution rates amount to less than 6 per cent of pre-tax earnings.

“If people think 8 per cent of their whole salary is being saved, they will have an exaggerated impression of how much is being put aside for their retirement. The great thing about defined contribution pensions is that it is very easy to see how much cash is going into your account. People should be encouraged to look at these figures in relation to their total incomes and think whether they can afford to save more,” he adds.

“When so many of the target group are on low incomes, it is doubly important to make life easy for employers who want to maintain defined contribution schemes which use basic pay to calculate contributions. For someone on £17,000 a year, a 3 per cent employer contribution will be worth £510 if based on their whole salary but only £359 if based on banded earnings,” says Macro.

The good news for the DWP is that, provided their assumptions hold true, two-thirds of people who enrol in personal accounts from age 22 will see their income rise by around a fifth by the time they retire.

The Government also expects a 52 year old earning £11,500 who saves 8 per cent of band earnings from 2012 until retirement to receive an additional income of £7 per week in today’s earnings terms. This additional pension income increases their net total income in retirement by around 4.5 per cent from what they would have received by not saving.

A 42 year old who earns £22,500 would get an extra £163;33 per week by saving 8 per cent of band earnings from 2012 until age 68, a 20 per cent increase in their net total income, according to the DWP’s figures.

These figures are a marked improvement on those presented to the House of Commons in a written answer to a question posed by former DWP minister Baroness Hollis last July. Back then the DWP confirmed that someone who was on £20,000 would achieve a replacement rate of just 2 per cent after 20 years in personal accounts and 1 per cent after 10 years. The discrepency is because the Hollis answer related to someone annuitising at age 52. But whatever the figure, some in the industry say it is time to come clean on future means-testing policy.

Andrew Tully, senior pensions policy manager at Standard Life, talking about the more recent DWP figures, says: ‘These findings indicate that means-tested benefits are necessary to keep older savers above the poverty line. However, if means-tested benefits are promised to younger savers who will be automatically enrolled in a pension scheme from 2012, many will choose to opt-out. The Government should start to scale back means-tested benefits from 2012 as these workers will be entitled to an employer pension contribution that the previous generation weren’t.”

That would be a mammoth step – effectively promising to reintroduce pensioner poverty in 10 or 20 years time – which makes it unlikely. The current fudge, confusion and reliance on apathy seem a more appealing option for ministers.