How much is enough?

Before someone can work out how much money to invest for tomorrow, they need to understand what their contributions really cost them today.

The minimum contribution rate in the UK’s automatic enrolment system is 8% of a band of earnings. The employee usually makes up half of this amount, net of tax relief. The great majority of people who have been automatically enrolled into Nest and other schemes have never changed that default, and are still saving at that rate.[1] Yet it’s become something of a truism to say that 8% is not enough to deliver an adequate retirement income for most people. The Automatic Enrolment Review 2017 recommended this level be reviewed and, more recently, industry trade bodies called for a 12% rate.

There are good reasons to say that many defined contribution (DC) savers need to contribute more. Still, given the diversity of people’s financial lives, it’s hard to say with certainty exactly who is saving too little – or indeed, too much.

Relative or absolute?

What’s needed is a clear definition of ‘pensions adequacy’ – the optimal level of retirement income that any given individual should aim for. There has been a long and active debate in the retirement industry and among policy-makers about which measure of adequacy is the most suitable.

Relative income benchmarks are often used. In this approach, you calculate someone’s target retirement income by multiplying their working-life income by a ‘replacement rate’ that is generally lower than 100%. For instance, someone retiring on a salary of £50,000 might be recommended a pension income of £33,000, based on a replacement rate of two thirds. This approach was embraced by the UK’s Pensions Commission, who offered a range of earnings-related replacement rates in a series of reports[2] that were the foundation for the automatic enrolment policy.

Relative targets are appealing because they take into account the fact that higher earners should usually target higher retirement incomes than lower earners, who have less capacity to save. Still, as pointed out in a number of recent studies, replacement rate models are blunt instruments that do not take account of people’s highly varied living standards. Some people’s consumption will be much lower in retirement than it was during their working life, and replacement rates of 50% or more may be too high for them. For others, they may be too low. It depends on the financial circumstances of the individual’s household, and on their lifestyle – and on how these might change at retirement. Replacement rates also fail to set a bare minimum rate that the individual needs to save if they are to cover their essential costs in retirement.

More recently, these kinds of concerns have encouraged a shift of focus from relative benchmarks to absolute income standards, based on typical households’ consumption needs, expressed in pounds and pence. This includes the Pensions and Lifetime Savings Association’s (PLSA) Retirement Living Standards, along with the Living Wage Foundation and Resolution Foundation’s Living Pension benchmark. These initiatives have significantly shifted the terms of debate. Absolute models generally define a minimum income level that everyone should aim for, in order to be able to afford the basics. Often, they also suggest alternative, higher target incomes that certain savers might aim for, such as the PLSA’s ‘Comfortable’ living standard.

A fuller picture

Despite these positive developments, retirement income adequacy benchmarks on their own can’t give definitive answers to the question that’s actually facing individual savers: ‘How much should I save for retirement?’ Income targets for pensions help people focus on the rate at which they are building up a pension asset, but they don’t take into account other vital financial factors:

  • Financial wellbeing in retirement is highly dependent on non-pension assets and on the overall financial resilience of a household during the breadwinners’ working life. Consumption benchmarks tend not to include housing wealth – even though owning a home can make as big a difference to a person’s retirement wellbeing as the value of their pension savings. Carrying debt into retirement also has a significant impact on income needs.
  • People’s consumption and spending power changes during their working lives. Standard economic models of retirement saving assume that the goal is to smooth consumption across their working life. The idea is that, at certain stages of their careers, their income will outstrip their consumption, allowing them to save the surplus for retirement. Across the whole life course, consumption is flattened to a horizontal line. Yet we only need to look at the current inflationary context to see that consumption capacity fluctuates during working life. Even in less stretched economic times, the changing size of the household causes significant fluctuations, and many careers include periods of non-earning, or reduced wage growth. Taking all of this into account, a sustained period of reduced consumption should imply a reduction in lifetime retirement saving.

A new perspective on adequacy

A richer model of adequacy needs to allow for the enormous differences between the financial lives of different people in different circumstances at different times of life – and for the different strategies they might have. Some will want to maximise their chances of being able to buy a property before they retire. Others will need to tackle the short-term costs of servicing debt. For certain people, the ‘right’ level of retirement savings will be lower than the amount recommended by traditional models of adequacy at certain times in their lives. In some cases, their target savings rate may even be zero, at least in the short term. Better understanding these moments will allow for better targeting of nudges and other interventions that can help people make the right choices at the right times.

That’s why we’re delighted that Phoenix Insights is supporting our work on pensions adequacy and the household balance sheet. Using the PLSA benchmarks as a starting point, and overlaying data on the household balance sheet and the cost of living, we are working on a more contextual model of retirement savings adequacy. To help make sure we consider all relevant evidence, we’re currently seeking opinions from across the policy and retirement savings sectors. Please do get in touch if you can provide insight or evidence to help us with this process:

Matthew Blakstad, Director of Analysis and Governance at Nest Insight

[1] See for instance Nest Insight’s series Retirement Saving in the UK

[2] Pensions Commission (2004) Pensions Challenges and Choices, HMSO