January 2008

Reforming the right way

Two years ago, Adair Turner sent out a very stark message to the UK. Not enough people were saving for their retirement and action had to be taken. This could be working for longer, taxing people more to cover the higher state pension burden, or people saving more money. Or more likely a combination of all three.

The UK Government took the bull by the horns. It introduced changes to state pensions, and now a legislative bill of proposed changes to private pensions, requiring all employers to auto-enrol most of their employees into a pension scheme and pay a pension contribution for them.

These proposals should help to turn around the situation. We need more people saving for their retirement. At the moment millions of people are already doing exactly that, and it's fundamental that in-coming proposals don't disturb this current pattern of saving.

Employers will have to auto-enrol their employees into either their own qualifying pension scheme or personal accounts. Contract-based schemes - such as group personal pensions (GPPs) - don't fit neatly into the Government's pensions reform proposals. A European legislative anomaly means employers can't auto-enrol their employees into GPPs. Instead, they have to use work-around solutions such as streamlined joining or contract-joining. All of which have been very successful in increasing the take-up rates for these types of scheme.

The Government has to keep this at the forefront of its mind when setting the terms of the qualifying pension scheme. If it makes the terms radically different to the way GPP enrolment works now, it runs the risk of pushing employers into changing their GPP - levelling down contributions, closing to some employees, or maybe abandoning them for personal accounts. The penalties for doing so could be severe for their employees.

AEGON has recently done some analysis showing for low-to moderate-earners, the pension income paid out after 25 years of saving into a personal account with a 3% employer contribution, is roughly the same as the income paid after 20 years saving into a typical GPP with a 5% employer contribution. This assumes 0.5% a year charge for personal accounts and 1% a year charge for GPPs.

In other words, levelling down from a GPP to a personal account could knock five years of saving off someone's final retirement income.

This is because contributions to personal accounts will be based on band earnings, while GPP contributions are based on full earnings, and employer contributions are usually higher than the default 3% personal account level.

The details of the qualifying pension scheme aren't written on the face of the Pensions Bill published in early December. Instead, we are discussing now exactly how it will work. However, GPPs have to be part of the final solution. Providers and employers have to have enough freedom to use innovative ways of encouraging take-up rates and reducing the number of people who opt out.

It's imperative we get a sensible solution to the qualifying scheme test, or GPPs will simply level down or close, and the larger average contributions will be lost. Employees will lose out, possibly to the tune of five years' extra saving, but also by losing a head start in pension income when it comes to beating the means-testing trap in retirement.

Getting today's savers to pay more into their current GPP pension plans, and more employees to join those schemes when offered can help boost people's retirement saving. However, if employers level down or close their GPPs and switch employees to personal accounts, overall savings will fall. That will defeat the aims of pension reform.

Rachel Vahey
Head of Pensions Development
AEGON Scottish Equitable