Pensions World

What is an"adequate" pension? asks Amy Bell

With auto-enrolment, the majority of (private sector) workers will become members of a defined contribution (DC) plan. As employers prepare for auto-enrolment, many are considering what type of plan design to use. The number of new savers to workplace pension schemes as a result of auto-enrolment is estimated by the Department for Work and Pensions (DWP) at 9–10m. Will these new DC savers automatically assume that they are saving adequately for their retirement?

The cheapest option for employers considering scheme design is to make statutory minimum contributions for some or all workers. By the time phasing is complete, for someone earning £25,000 this would lead to total contributions of about £1,543 a year (in today’s terms). Will saving this amount each year provide an adequate pension income?

Maintaining standards

What does a worker really want or need in retirement? The term replacement ratio is frequently used to help target a certain level of income in retirement – if a retiree has a pension income that is half the salary they were earning while in work, their replacement ratio would be 50%.

The level of replacement ratio that is “adequate” is likely to vary from person to person as retirement aspirations are individual. There are certain basic essentials that all retirees need to achieve to live comfortably in retirement (food, heat, housing and so on). These costs lead to a minimum level of income required in retirement and result in higher desired replacement ratios for low income workers.

Towers Watson’s Pension Adequacy – The challenge for defined contribution pension plans shows that the average worker expects to need a pension of around 65% of their salary before retirement.

Critical factors

The key drivers to achieving pension adequacy are investment returns, pension contributions, prevailing annuity rates, the state pension and the level of wage growth. Different workers in the same company are likely to achieve very different levels of income of retirement. Low income workers desire higher replacement ratios (pension income relative to their working salary) to ensure an “adequate” retirement income, but low income workers find higher replacement ratios easier to achieve (because of greater state benefits and lower salary growth). Middle and high income workers are at greater risk of failing to achieve a pension consistent with their desired income in retirement. For low income workers, in particular, having a sustained pension contribution history is critical to producing adequate retirement incomes. For middle and high income workers, greater contributions and a greater focus on investment returns are required.

The Figure shows the significant volatility and range of outcomes that workers with DC pension plans can expect in the future as a result of volatile market returns and annuity rates. It is unlikely that workers are prepared for this degree of uncertainty with their retirement incomes.

While considering how best to meet the auto-enrolment requirements, fiduciaries and sponsoring employers arguably need to focus on understanding and managing the retirement “outcomes” of their workers to help structure investment and contribution design. Some workers who have previously not saved for retirement may think that statutory minimum (or higher) contributions will provide them with a replacement ratio far above what they will actually achieve (even when combined with state provision). Adequacy is a theme which should be a key message.