Personal Accounts: Section 4: What this will mean for individuals?

62. Personal accounts are designed for the approximately 10 million people who are currently not participating in a pension scheme offering at least a 3 per cent employer contribution, are aged between 22 and State Pension age and earning over £5,000. This is the target group for personal accounts. We know that employees who are not currently contributing to a private pension tend to be younger and on low to moderate incomes. They are also likely to be part-time workers and/or to work for small employers. A high proportion of women are lower earners and are less likely to be members of an employer pension. Personal accounts will help to address this.
63. We propose that:

    • individuals will be automatically enrolled if they earn above £5,000;
    • employees will pay contributions of around 4 per cent on their earnings between approximately £5,000 and £33,500 a year³⁴;
    • the employee contribution will be matched by 3 per cent from the employer together with around 1 per cent in the form of normal tax relief from the State³⁵;
    • the band of earnings on which contributions will be paid will be uprated in line with earnings to ensure the scheme is sustainable;
    • employees aged over 22 and below State Pension age will be eligible for automatic enrolment; and
    • employees outside these age bands will be able to opt in to the scheme, with access to an employer contribution if they fall within the earnings bands.

64. The Pensions Commission argued that a voluntary approach would never be enough to change pension savings behaviour. They recommended that we create a new form of saving, where employees are automatically enrolled into a pension, and have to make an active decision not to save, to tackle the problems of the short-termism and inertia of savers.
65. This does not mean employees will be compelled to save. The Commission rejected a compulsory approach to private saving because there will always be some groups who should not be saving towards a pension – for example those paying off high burdens of debt. But the Commission argued that automatic enrolment was necessary to help people make the right choice for their retirement and the Government agrees.
66. Evidence shows that automatic enrolment is one of the most effective ways of combating people’s tendency not to act when faced with difficult financial decisions.³⁶ Automatic enrolment has the greatest impact among groups where participation rates are low. American research into 401(k) schemes showed that automatic enrolment had the largest effect among people with low incomes, minority ethnic groups and women.³⁷

    Responses to automatic enrolment

    “The CBI supports automatic opt-in policies and has consistently encouraged firms to consider introducing such a practice.” (Confederation of British Industry)

    “We believe the ‘soft compulsion’ of auto-enrolment represents the right balance between encouraging and forcing saving.” (Age Concern)

    How will automatic enrolment work in practice?

67. When an employee starts work, they will be automatically enrolled into a pension; either into a personal account or into their employer’s pension scheme. We have decided that employees aged under 22 should not be automatically enrolled in this way, because the evidence suggests they are more likely to move jobs more frequently.³⁸ The administrative costs associated with frequent job changes in this age group might reduce the incentives for employers to hire younger workers. In addition, it is likely that younger workers’ employment is more sensitive to non-wage costs, which is why the minimum wage has a lower rate below 22.
68. Employees will contribute around 4 per cent of their salary on their income between the earnings limits of around £5,000 and £33,500. This will be matched by a contribution of 3 per cent from their employer and around 1 per cent from the normal tax relief available on individual pension contributions.
69. The Pensions Commission recommended an 8 per cent combined contribution with the goal of providing a minimum level of pension for most people. Based on their research with individuals³⁹, they argued that the minimum the median earner wanted in retirement was 45 per cent of their working income. These contribution levels are intended to achieve that level, although actual outcomes will obviously depend on a number of factors, for example investment returns.
70. Many people will want more than this level of pension and should, therefore, benefit from additional contributions. These extra contributions would attract normal tax relief but not a matching employer contribution. The personal accounts board will be given a duty to encourage saving above the minimum level of contributions.
71. Once personal accounts are up and running and a new employee already has a personal account from a previous job, the employee could be ‘fast-tracked’ back into personal accounts. Figure 5 illustrates the individual experience of being automatically enrolled into a personal account.

    Figure 5: The individual’s experience in personal accounts

    
72. Government provides generous tax relief to those who save in tax-advantaged pension schemes to encourage individuals to save for an income in retirement. Personal accounts will be a tax-registered pension scheme and so individual savers will have access to pensions tax relief on contributions. This means that for a basic rate taxpayer every £1 saved will be matched by 28p from the State.
73. Automatic enrolment will help people save for a pension. But it does not replace people’s responsibility to ensure that their retirement income meets their expectations. The goal of our policy is to give people a reasonable expectation that if they save in a pension they will be better off for having done so. Whether to save or not must remain the individual’s decision.

    Impact of the state pension reforms

74. The state pension reforms currently before Parliament will provide a firm foundation on which people can build through their private saving to reach the standard of living they would like in retirement:

    • Increased coverage of State Pensions – in the past, women and carers have not had the same access to State Pensions as men. After reform, around 75 per cent of women reaching State Pension age in 2010 will be entitled to a full basic State Pension and this will reach over 90 per cent of women (and men) by 2025.
    • Reduced reliance on Pension Credit – restoring the link between earnings and the basic element of the State Pension, and changes to how Savings Credit is calculated, will ensure that Pension Credit remains targeted at the groups who need it. We estimate that without change and assuming continued uprating policy, by 2050 around 80 per cent of pensioner households would have been entitled to Pension Credit. With the reform package, that will fall to around 30 per cent in 2050. This will mean that there will be greater benefits of saving for more people.

75. The state reforms will ensure that Pension Credit is targeted at those who need it – namely, groups who have not been able to contribute for enough years to build up rights to a sufficient State Pension.
76. As a result of the reforms, anyone who contributes for 24 years or more will be lifted above Guarantee Credit only. The Government will be able to give workers a reasonable expectation that if they work and/or care, and save, for most of their career they will not be on Pension Credit on retirement. Without reform, that would not have been possible.
77. Pension Credit will continue to be an important safety net for those who are not able to make such provision – but there will still be good incentives to save.
78. Lower charges and the presence of an employer contribution will directly enhance the value of pension funds. Payback will clearly depend on a range of factors such as investment performance⁴⁰. However, in the reformed system, in real terms, a median earner aged 25 in 2012 might expect payback of £2.55 for each £1 saved, compared with £1.13 for every £1 saved without reform, as illustrated in Figures 6a and 6b⁴¹. Someone receiving Savings Credit in 2050 could still get a return of £2 for every £1 saved.
79. The result of the reforms, bearing in mind the difficulty of all long-term predictions, is that there will only be a small group of people – less than 10 per cent of pensioner households in 2050 – who may not see any benefit from saving. To fall within this group, people would have to have a severely deficient state pension record and not have earned above £5,000 in many years of their working life. They are thus unlikely to have been automatically enrolled into a personal account or alternative pension scheme for long, and will have accumulated relatively small pension funds. Even this group may benefit as they will be able to take their pension as a lump sum if the total is less than the trivial commutation limit (£15,000 in 2005/06).
80. The reforms to State Pensions combined with the employer contributions mean that the incentives to save are better for all age groups compared to the system prior to reform. Very few people will see little or no benefit from saving. The majority will see significant returns.
81. Some people will rightly decide not to save for a pension. They could include those on persistent very low incomes or those struggling with high unsecured debt. But the large majority of people can expect to benefit from saving. Ultimately, it should be for the individual to decide whether and how much to save based on their particular circumstances.

    Figure 6a: Potential payback from £1 contribution for a male median earner aged 25 in 2012, without proposed reforms

    
    
    

    Figure 6b: Potential payback from £1 contribution for a male median earner aged 25 in 2012, with proposed reforms

    

    Source: DWP modelling

    Notes: Median earnings in 2006/07 are £23,000.
    This figure is for illustrative purposes only. It should not be used as the basis for individual decisions as specific circumstances or variation from the underlying assumptions will lead to different results.

    34. When launched, the limits for the personal accounts earning band will be aligned with the Primary Threshold and Upper Earnings Limit for National Insurance contributions (£5,035 and £33,540 a year respectively in 2006/07).
    35. 1 per cent represents basic rate tax relief on individuals’ contributions – in addition, individuals may be entitled to higher-rate tax relief and neither employers nor employees pay tax or National Insurance contributions on employer contributions.
    36. The Employers’ Pension Provision Survey 2005 findings show a link between automatic enrolment and increased levels of pension scheme membership. Within private firms with 20 or more employees, the proportion of employees that were in a pension averaged 60 per cent (median 77 per cent) where the firm used automatic enrolment. This compared with 41 per cent for traditional opt-in.
    37. Madrian and Shea, 2002, in Munnell and Sunden, 2004, Coming up short: The challenge of 401(k) plans, The Brookings Institute.
    38. Under 22-year-olds are more likely to move between various labour market states and change employment than people over 22. This is based on average annual flow data, Labour Force Survey, spring/summer 1997 to winter/spring 2004.
    39. Pensions Commission, 2005, A new pension settlement for the twenty-first century: The second report of the Pensions Commission, TSO.
    40. Financial incentives to save for retirement, November 2006, www.dwp.gov.uk/pensionsreform/pdfs/financialincentives.pdf
    41. These savings are reinforced by Sefton J, van de Ven J and Weale M, December 2005, The Effects of Means-Testing Pensions on Savings and Retirement.