Personal Accounts: Section 1: The need for reform

1. Pensions are complicated, but the idea behind them is simple – save now to spend later. Yet too many people find it difficult to save what they need for retirement. Estimates suggest around 7 million people are not saving enough for retirement. Only 40 per cent of those who have not yet retired are saving for their retirement at all – yet 80 per cent say that they will need more than a State Pension to live on.¹
   
2. Although parts of the pensions market work very well, it is failing for people on average and low incomes who do not have access to a company scheme. It is difficult for customers in this group to find the right kind of pension product for their circumstances and pension providers cannot profitably supply what is needed.²

   Lack of demand

   ”I don’t really know what goes on in how to set up a pension or anything like that, but I know that you do it at the age of around 40/50. I’ve never actually thought about doing it, it’s not something I talk about with friends or anything.”
   (Not saving, 18–21, £10-20k)³

   ”You think about it and think I’ll deal with it another time and then that other time don’t come.” (Not saving, 31–65, under £25k)⁴

3. Consumer demand for pensions is lower than would be needed to fund the retirement people expect. Behavioural economics suggests that there are two main reasons for this:
   • choice paralysis -people know that choosing a pension is an important decision, but the difficulty of making the right choice often stops people making any choice; and
   • living for today - it is easier to make decisions about today, than about what will happen in 40 years. Many do not want to think about getting older, let alone how to save sufficient money for their retirement.

4. As well as being insufficient, the demand for pensions is often ineffective. Consumers on moderate incomes typically do not understand pension products well , find it hard to make comparisons, and rarely switch providers. Research by Oxera for the Association of British Insurers (ABI) found that under 4 per cent of personal pension customers and just over 2 per cent of stakeholder pension customers switch; this is lower than the switching rate observed in sectors such as fixed and mobile telephones, mortgages, car insurance, gas or electricity, and only slightly higher than that observed in banking. The result is that customers do not impose effective pressure on providers to reduce cost or improve quality.
5. This is not true of the successful parts of the pension market. In occupational pension schemes, for example, trustees act as informed customers (supported by professional advice) and are able to exert more effective pressure on providers. And for the better off buying personal pensions (including stakeholder pensions), there is the independent financial advice network to help them.

   Supply gap

6. The Pensions Commission’s research suggests that it costs around £800 to sell a personal pension to someone working for a medium-sized employer. However, consumers often do not persist in making contributions. More than a third of all personal pension contracts lapse after four years and this percentage is increasing.10 Assuming present persistency rates continue then, of personal pensions started today, only 40 per cent will still be receiving contributions in ten years time.¹¹
7. The combination of high up-front costs and non-persistency means that providers have a relatively short period in which to recoup the large set-up costs. This has two implications:
   • firstly, it leads to relatively high charges. Few personal pensions (sold on an individual basis) have charges significantly below the stakeholder pension cap of 1.5 per cent of funds under management.¹² This compares to many occupational pensions which charge 0.3–0.5 per cent; and  
   • secondly, it means that it is not economic for providers to sell individual personal pensions to consumers on low and moderate incomes. The high costs of advice in relation to the low level of funds under management result in disproportionately high charges. High earners, who will have more funds in the scheme generating higher revenue, or those working for large employers – where economies of scale are easier to achieve – are more attractive.
8. In addition, there have been problems such as mis-selling and scheme failures in the supply of pensions which have dented trust in the market. In both cases, assistance was put in place to rebuild confidence. For the future, the Pension Protection Fund (PPF) has been introduced to act as a safety net for today’s occupational pension schemes.

   Ineffective competition

9. It is clear that competition alone is not sufficient to deliver simple, low cost, long-term savings products for those on average incomes without access to a good company pension. A well functioning market should produce improved outcomes for individuals, such as better service, reduced charges and innovative products. But the Sandler review¹³ found that this did not happen in the pension market, concluding that:

   • “…competitive forces do not always work effectively to deliver value. Charges for near-identical products can differ widely.”; and
   • “It is noteworthy that, in contrast to many other industries, the unit costs of the life industry have risen significantly in recent years.”

10. The impact of fees and charges on the investment return in personal pensions has declined significantly since the mid-1990s, from around 1.9 per cent in 1995 to around 1.1 per cent in 2002 as shown in Figure 1. However, this may have been driven by regulation rather than competition. The Pensions Commission reported¹⁴ that the decline: “…to a significant extent reflects the introduction of the stakeholder pension charge cap, set at 1 per cent annual management charge (AMC)...in 2001, and regulatory guidance from the Financial Services Authority which has meant that financial advisers could not recommend products with charges significantly above this price cap.”

    Figure1: Impact of regulation on charges over time

    

    Source: FSA disclosure reports and comparative tables

    Scale of the challenge

11. Where the problems of low demand and supply do not apply, the pensions market works very well. Company pensions achieve much lower charges. People who work for a company with a good-quality pension scheme are more likely to be saving for a pension than those who are not in that position. As can be seen in Figure 2, the higher the level of employer contribution in employer-sponsored provision, the higher the participation rate.

    Figure2: Existing pension provision: scheme membership by contribution levels

    

    Source: DWP analysis based on Employers’ Pension Provision Survey 2005, Small and Medium-sized Enterprise (SME) Statistics 2005 and Annual Survey of Hours and Earnings 2005

12. Where employers are engaged in pension provision, and employees are participating, employees are able to build up good pensions. However, as identified by the Employer Taskforce on Pensions¹⁵, there has been a retreat by employers from providing pensions and the Pensions Commission concluded that this trend was unlikely to be reversed.

    Figure 3: Membership of current employer’s pension scheme for full-time employees 1979 to 2004

    

    Source: General Household Survey, GB

    Notes: Full-time employees aged 16 and over. Prior to 1985 full-time students are excluded. Later figures include full-time students who were working but exclude those on Government schemes. Figures include a few people who were not sure if they were in a pension scheme but thought it was possible. Data from 2000 onwards are weighted.

13. Overall participation in occupational schemes is falling as illustrated in Figure 3. In 1979, 65 per cent of employees were members of their current employer’s pension scheme compared to 57 per cent in 1995, and around 54 per cent in 2004.¹⁶The percentage of private sector employees participating in occupational pensions fell from around 40 per cent in 1991 to around 25 per cent in 2005.¹⁷

14. The Government wants to support employers providing pension schemes. The combination of problems with both demand and supply, and a lack of effective competition within some sectors of the pensions market, mean that a voluntary approach to private saving is unlikely to be sufficient to tackle the current barriers that prevent people from saving optimally. This trend is particularly pronounced amongst young people, with fewer of those in their 20s and 30s saving than even five years ago.¹⁸
15. The Pensions Commission found that between 9.6 and 12 million people were undersaving based on the benchmarks they set out. Further analysis by the DWP has refined that estimate to around 7 million people.¹⁹
16. Without action, millions of today’s workers could retire without having built up sufficient pension savings to fund the lifestyle they are expecting. The Commission concluded that a voluntary approach to private pension saving would not be enough to close that gap. ¹⁷.
17. Automatic enrolment into existing stakeholder schemes would go some way to dealing with the lack of demand in the pensions market for our target group, by overcoming the inertia that leads many individuals not to make a decision to save. It would also increase the number of savers and the amount of savings in stakeholder schemes. However, automatic enrolment into stakeholder pensions would not help to increase the persistency of saving, because members would not automatically stay in the same pension when they moved jobs. This could also lead to increased burdens on employers. Our work, and that of the Pensions Commission, suggests that this would not lead to a significant reduction in charges for our target group and would therefore not represent good value. 
     
18. None of these problems are new but they could have more serious consequences as people live longer and fewer children are born. Today there are almost four working age people for each pensioner.20 By 2050, without action on the State Pension age, this would have fallen to two working age people for each pensioner.²¹
    
19. Without an increase in private saving, future generations could retire poorer than today’s pensioners, and poorer than they expect to be. This could lead to pressure to increase State Pensions, but the demographic trends would make this hard to fund. If there were only two working age people for each pensioner, the cost of dealing with the consequences of a failure to save would be very high, and fall disproportionately on future generations.

1. Estimates of the current level of undersaving for retirement are difficult to construct because they rely on different data sources, and there are measurement difficulties. The current DWP estimate is based on analysis by the Institute for Fiscal Studies (Banks J, Emmerson C, Oldfield Z and Tetlow G, 2005, Prepared for Retirement? The Adequacy and Distribution of Retirement Resources in England. Institute for Fiscal Studies).
2. Atkinson A, McKay S, Kempson E and Collard S, 2006, Levels of financial capability in the UK: Results of a baseline survey, Financial Services Authority Consumer Research Report, 47.
3. Green E and White C, 2005, Effective means of conveying messages about pensions and saving for retirement, DWP Research Report No 239.
4. Green E and White C, 2005, Effective means of conveying messages about pensions and saving for retirement, DWP Research Report No 239.
5. Chapter 2 sets out further details about behavioural economics.
6. Atkinson A, McKay S, Kempson E and Collard S, 2006, Levels of financial capability in the UK: Results of a baseline survey, FSA Consumer Research Report No 47.
7. Oxera, 2006, How to evaluate alternative proposals for personal account pensions: An economic framework to compare the NPSS and Industry model, commissioned by the ABI.
8. Pensions Commission, 2004, A new pension settlement for the twenty-first century: The first report of the Pensions Commission, TSO.
9. Lapse – either no new contributions are made or the funds are transferred to another provider
10. Pensions Commission, 2004, A new pension settlement for the twenty-first century: The first report of the Pensions Commission, TSO.
11. Pensions Commission, 2005, A new pension settlement for the twenty-first century: The second report of the Pensions Commission, TSO.
12. Falling to 1 per cent after ten years.
13. The Sandler Review of Medium and Long-term Retail Investment, July 2002
14. Pensions Commission, 2004, Pensions:Challenges and Choices, The first report of the Pensions Commission October 2004, See appendix C
15. ETF Report to the Secretary of State for Work and Pensions. Published December 2004 www.employertaskforce.org.uk 
16. General Household Survey, GB
17. Analysis based on the Government Actuary’s Department’s Occupational pension schemes survey and Office for National Statistics employment data.
18. Family Resources Survey.
19. Estimates of the current level of undersaving for retirement are difficult to construct due to: difficulties identifying appropriate saving targets; uncertainties about which kinds of wealth and asset to take into account; difficulties projecting individuals’ future saving and working patterns, particularly around choice of retirement age; reliance on inadequate data; and reliance on a range of other uncertain assumptions, including the impact of future macro-economic developments. Consequently, such estimates should be treated cautiously. The current Department for Work and Pensions (DWP) estimate draws on analysis by the Institute for Fiscal Studies (Banks J, Emmerson C, Oldfield Z and Tetlow G, 2005, Prepared for Retirement? The Adequacy and Distribution of Retirement Resources in England, IFS). The May 2006 White Paper (Security in retirement: towards a new pensions system) sets out some of these issues in more detail.
20. Working age is defined as those aged 20 to 64 for both men and women. Pensioners are defined as those aged 65 or over for both men and women.
21. Analysis based on the Government Actuary’s Department’s 2004 population projections. The proposed changes to State Pension age will increase this ratio from two to one, to three to one.