Saving the losers

A critical success factor of pension reform is the extent to which it increases saving for retirement, particularly among lower earners and other groups who have lost out in the past. Without dramatically different savings habits large numbers of pensioners will continue to live in relative poverty, depending on means-tested government support.

This is illustrated by the yearly Scottish Widows UK Pensions Report, which has revealed that only half of those who could and should be saving for retirement are making adequate provision. With employer provision declining and the reduction in defined benefit (final salary) pension schemes, radical action is necessary to increase private savings.

This action, based on the recommendations of Lord Turner’s pensions commission, is being implemented through two pensions bills. The Bill which has recently been considered by parliament principally implements changes to state pensions, while the second Bill in the next session will introduce new personal accounts for individual saving.

Under the new system, employees will automatically be enrolled into personal accounts unless they actively choose otherwise. This initiative, which has widespread support, aims to improve pensions coverage through lethargy. Many people will not get round to arranging personal provision if they have to take special action, but will not decide to opt out.

Automatic enrolment carries the danger that some could ultimately end up worse off overall than if they had not saved at all. With personal accounts that danger is minimised through the employer contribution and tax relief. The minimum contribution by individuals is four per cent of earnings in a band between about £5,000 and £35,000 a year, and it is matched by a three per cent employer contribution and about one per cent in tax relief. Most people will therefore end up substantially better off than if they were simply saving for themselves.

However, a further factor is the impact of personal accounts on means-tested benefits. If the amount lost through reduced means-tested income is greater than the benefit of saving, the individual could lose out overall. To understand this, we need to consider the interaction of the state pension system with means-tested benefits.

The basic state pension provides a foundational retirement income, currently up to £87.30 per week for individuals. In the long term, probably from 2012, it will increase each year in line with average earnings, rather than with prices as at present. This will particularly benefit the lower-paid for whom the basic state pension can be a significant part of retirement income.

Employees also qualify for the state second pension. This additional pension is currently linked to earnings, but in the longer term will become flat-rate. This change, too, is likely to benefit the lower-paid. Those who have entitlement to the full basic state pension and who also have significant employment years which qualify for the state second pension will ultimately be well clear of means-testing in retirement.

The third element of state retirement provision is the means-tested pensions credit. This guarantees a minimum income of £119.05 a week for single people (£181.70 for couples). This minimum income is increased by the savings credit for those who have built up other personal income. Currently, the minimum increases by 60p for every £1 of income above the basic state pension. This is perhaps best illustrated by an example.

Mark has personal income of £127.30 a week, which is £40 above the level of basic state pension. The guaranteed income for Mark is increased to £119.05 plus £24.00 (60% of £40), or £143.05 a week. His top-up from the pension credit is £15.75 (£143.05 minus £127.30).

Mark loses 40p of state benefit for every £1 of his personal income. This could be more than he has gained in tax relief on his personal contributions, probably 22p in the pound, but if it partly comes from employer contributions he is likely to be better off overall. However, there are circumstances where there could be a much higher loss of means-tested benefit.

The first is where income is below the level where savings credit applies. At present, this is the level of the full basic state pension. Anyone who is not entitled to the full pension because of an incomplete record of National Insurance contributions and credits (and who is not entitled to state second pension or its precursor the state earnings related pension scheme) will lose part of income they have saved for themselves pound-for-pound.

From April 2010 the full basic state pension will be available to everyone who has at least 30 years of National Insurance contributions or credits, which will reduce this problem. However, a change to pension credit will increase it for some.

This change will reduce the number of pensioners relying on means-tested benefits in the long term. However, one side-effect will be that the starting threshold for the savings credit will gradually move above the level of the basic state pension, leaving an income band where pound-for-pound reduction to means-testing applies. This will mainly be an issue for those with little or no entitlement to state second pension.

The second circumstance where high withdrawal rate could apply to means-tested benefits is where individuals rent their homes in retirement. The Pensions Policy Institute has calculated that where pension credit is combined with housing benefit and council tax benefit the withdrawal rate could be as high as 91p in the pound. In other words, for every £1 saved (of which around 50p would be contributed by the individual through personal accounts) the net gain in retirement income is just 9p.

The scale of these issues is difficult to quantify. The problems mainly affect those who are single in retirement, because increasingly both partners in a couple will be eligible for the full basic state pension, and the pension credit entitlement for a couple is only around 60 per cent higher than for a single person.

Also, as the flat-rate state second pension matures it should lift many people beyond means-testing. Finally, increased home ownership should reduce the number of pensioner households dependent on housing benefit, which currently stands at around one in five.

The groups most likely to lose out through saving are those who are self-employed for much of their working lifetimes, those who have such broken career patterns that they may not qualify for a full state pension even after reform and those who never become home-owners.

The numbers involved long term are likely to be small as a percentage of the total retired population, but even if the total is well under one per cent of the total retired population it could still number tens of thousands.

The pension reform proposals form a coherent package of measures, and it would not be possible to make major changes that would address this problem in isolation without causing others elsewhere, perhaps by leaving more people dependent on means-tested benefits.

It is also unrealistic to expect to achieve a situation where everyone is better off through saving in personal accounts. That can only happen with government underwriting, which is highly unlikely.

The solution must involve smaller change to minimise the risk of loss, particularly for those automatically enrolled into personal accounts. One such measure would be to allow more people to cash in their pensions under the ‘trivial commutation’ rules.

Currently those with total pension provision worth under £16,000 can cash that in, instead of drawing it as pension income. Of the value 25 per cent is tax-free (reflecting the 25 per cent tax-free lump sum normally available from pensions) while the remaining 75 per cent is taxed as income. The advantage of trivial commutation is that modest amounts of capital do not normally result in as much loss of means-tested benefits as regular income does. So for those with relatively small savings commutation might well be preferable to a small pension.

The Equal Opportunities Commission recently commissioned the Pensions Policy Institute to consider possible changes to trivial commutation rules to benefit those with small retirement provision. The report, published on 11 June, examines among other things the effect of increasing the trivial commutation limit to £30,000 and the ‘capital disregard’ (the amount of savings not taken into account in means-testing) from the current level of £6,000 to £10,000. These changes would result in a significant reduction of the risk of losing out through saving at a relatively modest cost to the state. It is for parliament to decide whether this or other measures will be acceptable, but the risk of losing through saving must be minimised.

Automatic enrolment into personal accounts or other high quality pension arrangements represents an opportunity to improve pension provision significantly. Every effort must be made to minimise the inefficacy of savings, and this should form an important part of discussions preceding the second Pensions Bill in the next session of parliament.

Ian Naismith is the Head of Pensions Market Development at Scottish Widows.