Cicero Policy Briefer

Issue 25, June 2008

Will the Government’s pension reforms deliver (Part Two)?

By Chris Curry, Research Director, Pensions Policy Institute

In the February edition of the Cicero Policy Briefer Niki Cleal (PPI Director) looked at whether the Government’s pension reforms would deliver what they set out to achieve in encouraging more people to save to for their retirement. As well as the setting up of personal accounts, the reforms include auto-enrolment and compulsory employer contribution of 3 per cent where an employee wants to contribute to a pension.

There is broad support for the introduction of auto-enrolment as a way of increasing the number of people saving for their retirement. But two major concerns have been expressed. The first is whether it will pay for people to save due to the interaction of the new system with means-tested benefits. The second concern is the possible negative impact that auto-enrolment could have on the existing pension market if employers reduce the generosity of their existing pension schemes due to the introduction of auto-enrolment, often referred to as “levelling down”. This article addresses the second of these issues, based on PPI research published in November 2007.

While it is clear that the reforms are likely to increase the number of savers, using the inertia of auto-enrolment, it is less certain that the reforms will also lead to a greater amount being saved in pensions each year. Much will depend on how employers react to the cost increases that many of them will face when auto-enrolment is introduced.

Employers who don’t currently contribute at least 3 per cent will need to increase their contributions to that level. Employers who already offer a generous pension scheme will have a choice about whether to maintain their existing scheme for new and existing members or to change their arrangements. They could, for example, change their existing scheme by reducing contribution levels; introduce a new, less generous scheme for new members; or they could enrol new members into personal accounts at the minimum contribution level.

So, whether the reforms will lead to a greater amount being saved in pensions each year will depend on how employers respond to the reforms (Chart).

Chart

Without the reforms there could be a decrease in annual total pension contributions from around £40 billion in 2006 to around £30 billion by 2050. This is mainly the result of employers continuing to close Defined Benefit (DB) schemes and opening less generous Defined Contribution (DC) schemes in their place. After the introduction of the reforms in 2012 a wide range of outcomes is possible. The PPI has undertaken scenario analysis to illustrate the possible outcomes if employers were respond to the reforms in particular ways. These represent the range of outcomes that could occur—however, they are not intended to be forecasts of the future.

In a very optimistic scenario, if employers with generous schemes were to auto-enrol all of their eligible employees into existing schemes on existing terms, then the reforms could increase annual total pension contributions by around £10 billion per annum. This would result in the growth of the overall pensions market (see chart: existing terms). However, if employers with generous existing schemes were to reduce their average pension contributions to hold their pension costs constant, the reforms could still increase annual total pension contributions—but only by around £5 billion compared to the situation without reform (see chart: cost control).

On the other hand, in a very pessimistic and extreme scenario, employers could decide to only offer the minimum 3 per cent contribution for all new employees. If this happened, the 3 per cent minimum contribution would become the norm over time. While annual total pension contributions could initially be higher than without reform, by 2050 annual pension contributions could be £10 billion lower. This overall shrinking of the market could be particularly detrimental for existing pension provision (see chart: minimum terms).

In reality, employers are likely to respond in a variety of different ways. If employers act in line with a survey of their likely responses carried out by Deloitte in 2006, the reforms could initially increase annual total pension contributions by around £10 billion compared to without reform but this initial increase would wane over time as employers respond to the reforms by closing existing schemes to new members, reducing average pension contributions or auto-enrolling their employees into personal accounts. By 2050, the reforms could still increase annual total pension contributions in 2050, but by less than £2.5 billion above the level without the reforms (see chart: modelled employer response).

Overall, the jury is still out as to whether the Government’s pension policy will deliver both more people saving and more saving. And until we get closer to the introduction of auto-enrolment when employers start to examine the implications for their expenditure on pensions in detail, the jury will remain out.

Chris Curry is Research Director at the Pensions Policy Institute and can be contacted here.