Good morning from New Economy Brief.
Although they might not sound exciting, pensions are at the heart of some of the most pressing issues we face today. The Finance Innovation Lab has called the pensions system “a perfect storm of social, economic and environmental challenges, with big risks for people, prosperity and the planet”. Pensions should be a source of economic security, both for the people paying into them and the wider economy. But in reality, pensioners are often left without adequate income while pension funds invest in harmful practices like deforestation and fossil fuel production.
Last month, the new Chancellor launched a “landmark” two-part Pensions Review. The first phase will focus on how pensions are invested while the second phase, due to start later this year, will focus on “retirement adequacy”. In this edition of New Economy Brief, we’ll be focusing on the latter. How pension funds are invested is an incredibly important issue, with significant repercussions for the climate crisis and global inequality - we’ve touched on this before and will give it the space it deserves in the future. But for now, we will focus on the adequacy of pensions and what can be done to boost retirement incomes.
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The scale of the problem
The current pension system means that most people are saving far too little to expect adequate income in retirement. The UK state pension falls well below the OECD average and 80 per cent of those that are saving into defined contribution (DC) pensions (over two-thirds of the population) are not saving enough to expect a minimum income in retirement. Women are at particular risk for pension inadequacy, with the gender pensions gap well-documented. This is because the full state pension is linked to National Insurance Contributions (NICs) meaning that those with employment gaps due to caring responsibilities (often women) aren’t entitled to adequate pensions. The occupational pension system also reinforces labour market inequalities because contributions are linked to salaries, meaning that women, people of colour, disabled people and other groups will fare worst in retirement.
Adequate Pensions for All. So what can be done to ensure that everyone has access to an adequate pension? A group of trade unions and civil society organisations, led by the Finance Innovation Lab, have recently called for a number of measures to boost savings:
Increasing contributions. The group suggests that as well as retaining the “triple lock”, the state pension scheme could be reformed so that fewer years’ of National Insurance Contributions (NICs) are required to receive it. For occupational pensions, minimum employer contributions could be increased with support provided for smaller employers. Currently, the total minimum contribution for those auto-enrolled into a pension scheme is 8%, but just 3% of this must come from the employer (the rest from the employee). This is comparatively very low. In Australia, for example, the minimum employer contribution is 11.5%. Auto-enrolment could also be reformed so that people often left behind by the current system such as the self-employed and those with time out of the labour force can be included. For those on the lowest incomes, minimum absolute levels of employer contributions could be mandated so that, for example, those on the Living Wage or less could receive adequate employer contributions without having to pay large employee contributions.
Defined contribution vs. defined benefit. As we have already mentioned, the vast majority of workers pay into a defined contribution (DC) pension. This is the default model, in which the employee and employer pay into a pot which the retired person must then survive on until they die. There are of course two types of risks associated with this: an investment risk (the value of their savings at the point of retirement) and a longevity risk (how long the person will live in retirement and therefore how long the money will need to last). On the other hand, defined benefit (DB) schemes guarantee a set income for life. They depend on things like how long you worked for the employer and what your salary was, rather than how much you paid in or the investments made. The pension is paid each year for the rest of the retired person’s life, meaning that there is no risk of running out of money. The DB model, however, has been in decline for a number of years. The number of private sector employees still accruing new DB benefits reduced from 3.5 million in 2006 to just under 0.9 million in 2022.
Collective defined contributions. Another way that the risks associated with DC schemes can be reduced is via collective defined contribution schemes or CDCs. CDCs are very new in the UK, and were introduced via the Pensions Scheme Act 2021. Like traditional DC schemes, the value of pensions is subject to the success of investments. However the longevity risk of DCs are reduced by paying pensions based on average life expectancy across the scheme’s members. Some also argue that because investments are pooled between members, CDC schemes can take a longer-term investment strategy because they will contain a mix of members who are contributing to the scheme and receiving income from the scheme. The Royal Mail’s pension plan is due to be the first CDC scheme to go live in October.
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A wider context
Having said we wouldn’t get into the investment side of pensions, it is worth mentioning that how pensions are invested will affect the quality of life of future generations in retirement. Currently, many pension funds invest heavily in climate and nature destroying practices. It is estimated that for every £10 in the average pension pot, £2 is linked to deforestation. The more optimistic flipside to that is that as huge investors, pension funds could be key to providing the much-needed investment in a green transition. As is well-documented, the climate crisis brings with it economic insecurity and financial risks. What pensions invest in, therefore, has direct implications for living standards later on. Let’s hope that the two-part Pensions Review takes this wider context into account.
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Neoliberal economics, riots and disillusioned young men. George Monbiot blames neoliberal economics for fueling the recent far-right riots in the UK, as it “has enabled the formation of a new rentier class, that owns the essential assets and ruthlessly exploits younger and poorer people. Young men step into a world of promises - but find that all the golden doors are locked, and they do not have the key.”
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