First published in Pension Funds Online, 04 August 2017
The pensions model needs drastic change to avoid a bleak and expensive future for young savers.
Last week, the International Longevity Centre - UK (ILCUK) published a report concluding that young Britons need to save 18% of their earnings each year if they want an adequate income in retirement. They described this as being a "monumental challenge". Yep – you could say that. Their conclusion, though, is debatable. The "adequate" target they describe is two-thirds of pre-retirement income which, although it is the traditional and historic target for DB schemes and in many respects a desirable outcome, is probably a little simplistic given the resultant cost.
The Pension Commission (the body that came up with auto enrolment) described as adequate a range of 50–70% depending on where you were on the earnings scale, while The Joseph Rowntree Foundation set a much lower absolute target of just short of £10,000 a year for an individual (although this assumed a retirement bereft of any sort of comfort, much less luxury).
Either of these could be more appropriate and, as a result, the PLSA – in its report: Retirement Income Adequacy: Generation by Generation – adopted a hybrid approach, the cost of which for the AE population was, they calculated, 12%. A far more manageable contribution, but still very high compared to the current, historically low savings rate of below 2%.
Whichever way you cut it, and whatever you expect, unless you want to spend later life living under a bridge, retirement is an expensive business.
And our youngest cohorts of workers are hurtling towards it in the midst of a number of financial storms.
Firstly, they have huge debt. More people than ever are going through university and emerging with student loans which, currently, average more than £40,000. Now, of course, this is only paid off once earnings climb above a threshold, and can be written off after 30 years, but the fact is that these repayments reduce the amount of cash graduates have to spend or save elsewhere.
Secondly, their incomes are going backwards. In their report in July, the Resolution Foundation reported that earnings growth remains stubbornly below price inflation – i.e. "real" earnings are falling – and that this is particularly acute for younger people.
Thirdly, they have to deal with the costs of housing. This has, of course, been an issue for every generation, but the headwinds at the moment are particularly strong. In 1997 the average house cost around 3.5 times average earnings in England and Wales. By 2016 that was around 7.5 times (and while I don't want to get too London-centric about this, the ratio in the capital was 19.7!).
Now, of course, not all people own or aspire to own a house. Indeed, the number of 30-year-old home owners is 50% lower than it was 20 years ago – another problem in its own right for pension provision – and many will rent. The costs in renting, however, are also horrendous: in 2015 there were 35 local authorities out of 326 with a median monthly private rent equivalent to 50% or more of median monthly salary!
These three storms are putting pressure on all sides of pensions saving. But this isn't the end of it. There is another but unseen storm.
The Age Dependency Ratio describes the number of people below age 15 and above 64 relative to those in-between, i.e., broadly, the consumers relative to the producers. Currently the ratio is within an historically normal range, but it is climbing and is set to increase dramatically as a result of the baby boomers retiring and low birth rates since the early 1980s.
This is an important ratio for a number of reasons. The producers pay the taxes needed to fund benefits for the consumers. These benefits include the NHS, which is consumed disproportionately by the elderly. Fewer producers and more consumers can only mean one of three things: higher taxes, lower benefits, or a compromise between the two.
It's temping to think that an elected government (or at least a government that wants to be elected) will keep taxes low – but they won't be able to. The older generation, despite this year's election, is still more likely to vote. They have power and it would be a brave government that alienated them. (Evidence here? How about the threatened removal of the triple lock?) As a consequence, the IFS reported just before the election that the tax take is currently at a 30-year high.
Now, there may be compromise in order to mitigate some benefit costs (although state spending hasn't reduced despite austerity) but even if there is, it's a fair bet that the young will pay more tax.
Our youngsters have less gross income, even less net income, huge debts to repay and will struggle to be able to fund housing. And amongst these converging storms, they have to fund an increasingly expensive retirement. This model simply doesn't work.