BRIDGING THE SAVINGS GAP: AN EVALUATION OF VOLUNTARY AND COMPULSORY APPROACHES TO PENSION REFORM POLICY LESSONS

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1 BRIDGING THE SAVINGS GAP: AN EVALUATION OF VOLUNTARY AND COMPULSORY APPROACHES TO PENSION REFORM POLICY LESSONS INTRODUCTION This document accompanies a research report prepared for the Association of British Insurers (ABI) by PricewaterhouseCoopers (PwC). PWC s report sets out the results of modelling six scenarios for UK pension reform. This ABI paper draws out the main lessons for policymakers. The ABI s overall pensions strategy is set out in full in Serious about Saving: an ABI agenda for action on state and private pension reform. THE OPTIONS On the ABI s behalf, PWC assessed six of the most frequently-cited options for reform of the UK pension system and evaluated their fiscal costs and possible impact on saving in the UK. The key elements of the options assessed were: Option 1: no tax relief on pension contributions; no tax free lump sum; no taxation of pensions in payment; state second pension (and contracting out) abolished; state pension age increased to 70 (from 2030); Exchequer costs saved used to increase the Basic State Pension from around 82 to 120 per week, followed by earnings-related indexation. Option 2: the existing basic and higher rates of tax relief on contributions replaced with a single (30%) rate of tax relief. Option 3: 50% matching government contributions for private pension contributions used to replace existing tax relief up to 600 per year, beyond which further contributions would continue to attract tax relief. 1

2 Option 4: compulsory minimum pension contributions of 3% each from employees and employers, either with or without the removal of tax relief on these contributions. Option 5: auto-enrolment into company schemes for all employees (with the opportunity to opt out), assuming that all employers offered a pension scheme and made a contribution of 3% if the employee did the same. Option 6: the Pension Contribution Tax Credit (PCTC) employers who got a specified proportion of their workforce (assumed here to be two-thirds or more) into their pension scheme and then contributed a specified amount on their behalf (assumed here to be 5% for large firms (500+ employees) and 3% for small firms) would get a national insurance rebate (assumed here to be equivalent to 0.5% of earnings for large firms and 1% of earnings for smaller firms). METHODOLOGY As a first step, PwC surveyed published research to determine the likely change in savings behaviour from options 1 5, including the extent to which any increases would be offset by reductions elsewhere, or (for options 4 and 5), the extent to which savers already saving more than the default amount would reduce their savings. The following conclusions emerged from the literature survey. A higher real post-tax rate of return on saving was likely to have a modest positive effect - an increase of 1 percentage point in returns would lead to a possible increase in savings of around 3-7%. Higher income groups were more likely to offset (i.e. reduce saving elsewhere if they saved more in a pension), while increased pension saving for lower income groups was more likely to represent a genuine increase in overall saving. For the modelling, it was assumed that around 70% of any voluntary increase in pension saving would be new saving for those earning less than 10,000 pa, but only 25% for those earning over 40,000. Between 17% and 75% of compulsory savings might similarly be offset. The latest Australian study 1 suggested around 40%. Again, the offset effect was likely to be higher for those with higher incomes and this was reflected in subsequent modelling. 1 Connolly and Kohler (2004) 2

3 Studies on auto-enrolment indicated that only 10-20% of employees were likely to opt out. However, these studies also showed that, if the default rate were set quite low, people would tend to reduce their savings to that level. This was relevant for compulsion as well as autoenrolment. The results of the literature review were incorporated in a set of assumptions for the modelling of the savings behaviour of people in different income groups. On this basis, PwC created a model for testing options 1 5, using baseline data provided by the ABI and based on the results of a 2004 YouGov survey. A separate model originally developed by the ABI in 2002 and updated by PwC for this project was used to test option 6, according to a separate set of assumptions. RESULTS AND LESSONS FOR POLICYMAKERS Options 1-3 Table 1: Estimated effects on pensions and other savings Change in savings ( bn per annum) Option 1 (rate of return effects only) Option 1 (including loss of contracted out rebates) Option 2 (rate of return effects) Option 3 (rate of return effects) Pensions Other savings Total savings % changes - pensions +5% -13%* 2% 5% - total savings +2% -8%* 2% 2% *For Option 1 including the loss of contracted-out rebates, this is the % of total pension contributions or total savings, including employer contributions. For other columns, the % change relates only to individual pension contributions and total individual savings (excluding employer pension contributions). Source: PwC model estimates Option 1 PwC results Modelling of Option 1 (radical reform of the state pension system and of the existing tax regime) showed that reduced means testing for lower income groups (who would no longer be affected by the clawback of the Savings Credit element of the Pensions Credit) would outweigh the loss of basic rate tax relief. Higher income groups (unaffected by the Pension Credit) would by contrast be likely to reduce their savings because of the loss of higher rate tax relief. As Table 1 shows, the two effects together would give an overall increase in savings of around 1.3 billion per annum. However, this excludes the impact of the loss of contracting out. The model shows that this would remove around 10 billion from private pension saving, giving an estimated net reduction in savings of around 8.6 billion per annum. 3

4 The potentially very large negative impact on private saving of the loss of contracting out rebates needs to be taken very seriously. It significantly outweighs any benefit for lower earners provided by the reduction in means testing produced by Option 1. While the model has shown only the impact on private savings rather than on pensioner incomes, and this might be partly compensated for by an increased basic state pension, it is important to note that the people losing contracting out rebates would not be the same as those immediately gaining from an increase in the basic state pension. Money would be taken from the funded pensions of today s workers and paid to today s pensioners. Today s workers would receive only a promise that future tax payers would pay for a similarly high state pension for them. Given the Pensions Commission s prediction that the real problems for pension provision will occur in years time, this would seem to be a step in the wrong direction. Moreover, the model suggests that if means testing can be reduced without requiring the abolition of contracting out (and indeed of tax relief), then the positive impact of additional savings by lower earners could be achieved without the negative results. Using PwC s model ABI testing shows that reducing means testing alone could increase pension saving by around 3.7 billion, although there might be some offsetting reductions in other savings. Option 2 The model suggests that moving to a single 30% tax relief rate would have a relatively small impact on pensions and on overall saving about 0.7 billion per annum and 1.2 billion respectively. This is not surprising as option 2 would be broadly fiscally neutral in terms of the rate of return on savings. Basic rate taxpayers would be likely to contribute more to pensions, offset by a small reduction in other savings, while higher rate taxpayers would be likely to reduce their pension contributions, though much of this would be diverted to other savings. At present, only 17% of basic rate taxpayers and 28% of higher rate tax payers know how much tax relief they are entitled to 2. This suggests that one reason people are not saving enough is because they do not understand tax relief and so it does not fulfil its potential as an incentive. The results for Option 2 show only the likely direct behavioural impacts from a change in the rate of return on savings. This option would do nothing to achieve any more thoroughgoing change in saving behaviour. Changing the current amount of tax relief, therefore, is unlikely to achieve a significant step change in savings behaviour. A better approach would be to try to improve people s financial capability and understanding of the current incentives offered via tax relief. 2 see The State of the Nation s Savings, ABI

5 Until these incentives to save are properly publicised and given a chance to work better it would be premature to change them (with the costs this would entail). Option 3 Option 3 50% matching by the government of individual contributions up to a limit of 50 per month also has a relatively small impact if measured only in terms of the effect of the impact of the change to the rate of return on savings. Lower income groups (those earning less than 10,000 per year) would gain most from matching, and would be likely to raise their pension contributions, while higher rate taxpayers would lose out slightly and would be likely to switch some of their money from pensions to other savings. Overall, the effect on total individual savings is estimated by PwC as an increase of around 1.4 billion per annum. In principle, matching has the potential to do more than just boost the rate of return of saving for some. It is possible that matching might prove to be a good way of improving people s understanding of the incentives to save, with the result of an even greater increase in savings than the modelling estimates. In an ABI survey in almost two thirds of people said they would start to save, or save more, if the Government paid 50p for every 1 they paid into their pension as an alternative to tax relief. However, sensitivity testing carried out by PWC shows that it is wise to be cautious, and that the extra effect might be small. Options 2 and 3 would also be expensive to implement and might put extra pressure on occupational pensions in which the contribution is currently collected gross of tax. The obvious alternative is to educate people better about the current incentives to save before making any changes. 3 see The State of the Nation s Savings, ABI

6 Options 4 and 5 Table 2: Base case estimates of changes in savings in Options 4-5 Change in savings ( bn per annum) Individual contributions: levelling up Individual contributions: levelling down Net change in individual contributions Employer contributions: levelling up Employer contributions: levelling down Net change in employer contributions Total change in pension contributions Option 4 (compulsion) Option 5 (autoenrolment) (+17%) +2.8 (+9%) (+8%) +8.3 (+13%) +1.4 (+4%) +4.2 (+6%) Change in other savings -3.0 (-8%) -1.6 (-4%) Net change in total savings +5.3 (+5%) +2.5 (+2%) Note: % change from baseline shown in brackets. Source: PwC model estimates using baseline data provided by ABI (columns and rows may not add up exactly due to rounding). Option 4 Table 2 shows that compulsion (modelled as a 3% employer and 3% employee contribution) could increase total savings by around 5.3 billion or 5%. Much of this would come from lower earners. The impact of compulsion on the less well off leads to the question, whether it is in the interests of this group to be compelled to save when there may be better uses for their money, including paying off debts. Recent research for the ABI 4 shows that median debt (excluding mortgages) to income ratios are significantly higher for those with pension contribution rates below 5% of earnings than for those with higher contribution rates. This suggests that some of those not saving in a pension may have good short-term reasons for this. More compulsion might well force these people to save and get them further into debt as a result. It would be preferable to find a way of boosting saving which allowed those for whom saving was not appropriate to opt out. By contrast, saving amongst the highest income group (median income of 50,000) would be likely to fall, because most of them already have individual and employer contributions above 3%. 4 By YouGov to inform the report The State of the nation s savings 2004, ABI, November

7 Option 5 Auto-enrolment was modelled assuming all employers (except very small firms) offered a 3% pension contribution provided the employee matched this. This would provide a boost to pension saving of around 4.2 billion although the net effect on overall saving would be lower, at around 2.5 billion. While the increased saving would, once again, come mainly from lower income groups, under this option they would have the opportunity to opt out if saving was not appropriate for them. Again, saving amongst the highest income group (median income of 50,000) would be likely to fall, because most of them already have individual and employer contributions above 3%. (If auto enrolment began with employers offering any size of pension contribution and with no requirement for matching employee contributions, it might take time to reach the position modelled under this option.) A significant boost to saving could also be achieved via auto-enrolment, while maintaining the right to opt out. The potential downside of the option modelled would be the levelling down impact on the highest income group. (An effect is also seen with compulsion). This would be minimised if a specific level of contribution were not mandated (as this would avoid the you have saved enough signal given by the mandated level). The impact of levelling down could also be reduced by using further incentives and promotion of the need to save alongside auto-enrolment. This would be easier to do under an autoenrolment regime than with compulsion. Option 6 A separate model was used to estimate the impact of the Pension Contribution Tax Credit (PCTC). Depending on the response rate to the PCTC low, moderate or high the result could be an increase in pension contributions ranging from 0.9 billion to 1.5 billion. The PCTC avoids the problem of individuals poor understanding of saving incentives by targeting employers. Employers understand tax incentives and are more likely to respond to them. Moreover, the one incentive which individuals do respond to appears to be an employer contribution. ABI research 5 shows that a 5% employer contribution can increase the take-up of a scheme five-fold. There is therefore the prospect of a significant boost to savings from the synergy between these effects. 5 What makes people save? ABI December

8 ABI CONCLUSIONS One clear message from the research is that there is no magic bullet which, on its own, would significantly increase savings levels for people who need to save more and can afford to do so. While compulsion might increase savings, it is a blunt instrument, and would hit hardest lower earners for whom saving may not be the best use of their resources. Some people who do not save, or save very little, have high debt to income ratios and so are arguably making sound decisions. Compulsion also has the potential disadvantage that it may cause some better off savers reduce their savings. The research also suggests that there might be an alternative to the inflexibility of compulsion. Such an approach would create a solid state pension foundation on which a number of other measures could then be built, with a cumulative result as good as compulsion but without the downsides. As a first step, the state pension would need to be reformed so that means testing is reduced. This could result in around 3.7 billion extra private pension saving by lower earners who are currently deterred from saving because the Pension Credit would claw back some of their savings. This would need to be done without abolishing contracting out and tax relief, otherwise the positive impact on private saving becomes a negative one. A second step would involve getting people into existing workplace pension schemes via auto-enrolment. Further saving could then be encouraged by making people better aware of current levels of tax relief on pensions and further incentivised by measures such as the PCTC. Ideas like the Save More Tomorrow scheme being piloted in the US (whereby people commit a percentage of future pay increases to pension savings) could encourage yet more saving and ensure the default auto-enrolment rate does not become the maximum contribution rate. The impacts of all these measures could be multiplied significantly if the public s awareness and understanding about pensions were improved. Research conducted for the ABI shows that 48% of people feel that their understanding of pensions is fairly or very bad. The Government and the FSA are already taking steps to address this issue. The DWP s Informed Choice and the FSA s Financial Capability programmes are rightly focusing much of their work on the workplace. We fully support these efforts. A specific area where this could be beneficial is tax relief, as already highlighted. The ABI document Serious about Saving: an ABI agenda for action on state and private pension reform sets out in detail a package of proposals which we believe are needed to make the UK pension system fit for the 21 st century. 8