How can AE 2.0 accommodate low earners?

Auto-enrolment is a powerful tool but what about higher contributions and low earners?

We all know the UK is not on track when it comes to pension saving. The Department for Work and Pensions (DWP) estimates that around 12.5 million people are undersaving for retirement – and that’s before making adjustments to reflect that more pensioners are going to be renting in retirement in future, which will only push that number higher.

It seems inevitable that this will have to be addressed, at least in part by higher minimum contributions to automatic enrolment (AE) pension schemes. 

Of course, better engagement should be part of the solution too, because the answer to ‘how much should I save?’ will be different for everyone. But, if we want a positive impact on the greatest number of people, we need to look at what has worked most effectively so far, and that has been default savings. 

The AE extension bill will deliver some of this when it comes into effect and the minimum 8% contributions will at least be calculated from the very first pound earned, rather than discounting the first £6,000 or so, as the current rules allow.

A risk of oversaving?

But that doesn’t go far enough. A 12% contribution tends to be the magic number the industry is calling for. Not because it’s the ‘right number’ for everyone – a lot of middle and high earners would still be undersaving at this level – but because it looks achievable and might not be too scary when we consider impacts on take-home pay and labour costs. 

There are still some significant obstacles to getting there though – and one aspect we’re especially interested in is the position of low earners and the risk of oversaving.

Broadly, the risk is that people’s overprovision for retirement means they take on additional financial struggles during their working life. Previous research from the IFS (PDF, 721KB) found that AE was so powerful in leveraging inertia, that even financially insecure people who could benefit from opting out, tend not to do so.

This is a risk that might grow when AE rates are increased. A 12% contribution might be too much for the very lowest earners, particularly those in long-term, part-time work, for whom the flat-rate state pension will replace a decent chunk of their earned income. 

Of course, if they wish to retire before state pension age, they will be reliant on having saved money into their workplace pension. 

However, it is wrong to make a blanket assumption that 12% is too much for all low earners. For example, if we view this through a household, rather than individual, lens; a high-earning household might be made up of one person on a very high salary and one on a very low one. Between them, they can afford higher contributions from the low earner’s salary and would not want to miss out on the potential tax relief and employer contribution.

So, it is a complicated picture, as highlighted by the recent DWP research Low Earners and Workplace Pension Saving which examined attitudes and behaviours towards workplace pensions among low earners.

The DWP’s research revealed some misconceptions among low earners that pension saving might affect benefit entitlements, which may be of interest to employers, and anyone involved in pension communications.

But perhaps just as interesting as the results, are the hypothetical scenarios DWP tested, which included:

• Increasing the AE minimum contributions (with different variations of employer/employee split)
• Offering a more flexible approach to the employee contribution with an opt-down/up feature.

As you might expect, people tended to feel that matching employee and employer contributions was more appealing and ‘fairer’ than higher employee contributions. This could make it easier to accommodate low earners in future changes to AE, as a 6%/6% match would only require an extra 1% from employees, although we recognise that in the long-run, employers may need to offset higher employer contributions against future pay increases. However, it could still be the case that some low earners end up overprovisioned for retirement and could make better use of some of that money during their working life.

Appeal of a flexible approach

The flexible approach is interesting. The DWP research suggests that people found the idea appealing, though “potentially burdensome and confusing.” One challenge with this is that it would most likely require engagement, with people actively choosing to vary their own contribution levels. 

We’ve seen that people are unlikely to opt-up the employee contribution, would opting down be different? This is something worth testing further. The design of AE appears to presume that making the employer contribution contingent on employee contributions is necessary to reduce opt-outs, but perhaps there is a reasonable trade-off to be made, even if only for those earning under a certain amount. We can certainly see a case for the lowest earners having the right to retain the employer contribution even if they have to reduce or cease their own contributions.

It might also be possible to legislate for a flexible matching structure, where a 1% reduction in employee savings only sees the same size reduction from employers. Approaches like this are currently taken by some employers who contribute above the statutory minimum.

With AE 2.0 some years away, there is plenty of time for stakeholders to contribute their thinking to this challenge. 

For all it’s (many) merits, AE is a bit of a blunt tool when it comes to the contribution levels and some careful consideration of how to best accommodate low earners might just make it easier for a future government to start increasing contributions and get Britain saving enough.