Raising minimum auto-enrolment contribution rates requires a more nuanced approach and can’t be one-size-fits-all, writes Heidi Karjalainen of the Institute for Fiscal Studies (IFS).
Around 15 million working-age people are not on track to reach an adequate income in retirement, according to Department for Work and Pensions estimates.
The second Pensions Commission was set up to address this issue. It will publish policy recommendations next year, and is expected to propose changes to how automatic enrolment works.
There is widespread support within the pensions industry and among policymakers for increasing minimum pension contributions. But there is much less agreement about exactly how this should be done.
For example, some have argued that the minimum total contribution rate should increase to 12% from the current 8%. But the contribution rate is just part of the story – other features of the system will also play a crucial role in determining how changes affect retirement incomes and take-home pay today.
Changes to qualifying earnings bands
While it may seem like a technical detail, a particularly important choice is the ‘qualifying earnings band’.
Currently, minimum contributions are calculated as a share of earnings (8%) between lower and upper limits (currently £6,240 and £50,270). One way to increase pension saving would be to remove the lower limit completely, and calculate contributions ‘from the first pound’ of earnings.
There are sensible arguments for proposing this. The current system is not particularly intuitive or well understood, which means many people incorrectly assume they are already saving 8% of total earnings.
However, the effects of such a change would be proportionately much larger for low earners, who currently contribute a smaller share of their gross salary into pensions. Removing the lower limit of qualifying earnings, while keeping 8% as the total contribution rate, would increase the amount saved among everyone making minimum contributions by about £500 per year. This is clearly more consequential for low earners.
Of course, this translates to more pension saving, and thus higher retirement incomes. But recent IFS analysis shows that the effects on take-home pay are also significant, and more so for low earners.
The negative side of higher contributions
To see this, let’s assume the minimum total contribution rate changes to 12%, with a minimum employer contribution of 6%. If we keep the current qualifying earnings band, we calculate that lower earners (the lowest-earning 20%) would see a 0.3% fall in take-home pay, on average, due to the higher employee contributions they would make.
If contributions are calculated from the first pound, pension saving across those making minimum contributions would be another £750 per year more, and the fall in take-home pay for low earners would be much higher, at 1.7% of take-home pay.
In reality, the fall in take-home pay is likely to be even larger. This is because economic theory and empirical evidence suggest that the costs of higher employer pension contributions will largely be passed on to employees through slower wage growth over time.
There is uncertainty over the exact extent to which wages will be affected, but evidence suggests that the costs of higher employer pension contributions tend to be nearly fully passed on to employees.
Taking this into account, a 12% minimum contribution calculated on qualifying earnings would reduce low earners’ take-home pay by 1.2%, or 4% if contributions were calculated from the first pound of earnings.
This is significant, especially as around 23% of working-age people in working households currently have net household incomes after housing costs that are below the Pensions UK minimum Retirement Living Standard.
In other words, nearly a quarter of working people live on less today than the commonly used benchmark for a minimum standard of living in retirement.
It remains to be seen what judgement the Pensions Commission makes. But it’s important to keep an eye on the details and not just the headlines, as they will make a real difference.
Heidi Karjalainen is a senior research economist at the Institute for Fiscal Studies.
