CISI CEO Simon Culhane, Chartered FCSI, explains why paying a flat percentage into a pension fund isn’t necessarily the best option. Sometimes hares do win over tortoises
Most students of management and motivation theory will have come across the works of Abraham Maslow and his seminal book Motivation and personality (1954) which postulates that individuals have many needs which, he theorised, are ranked into five tiers.
According to Maslow, progression from one tier to another happens when the needs in the lower tier have been satisfied. For example, individuals need to have achieved the basic essentials for survival such as air, food, water, clothing before progressing to satisfy higher needs, such as personal, health and financial security.
Young people today, especially ‘millennials’ (those born between 1980 and 2000) have their own financial hierarchy of needs. For some, their priority is to pay off the overdraft they took out while they were learning (not their student loans which are really a graduate tax that reduces their disposable income). For others, it may be to pay off the loans they have used, or wish to take out, to purchase a major asset such as a car or increasingly, a technology based consumer durable.
At some early stage, the millennial is likely to aspire to own their own home and will want to save for a deposit or to start a family. Others may have different immediate priorities for their earnings, but relatively few will regard saving for an event over 40 years in the future as their primary requirement.
Principles of auto-enrolment
Yet, with pension auto-enrolment and the new changes that are being proposed, this is exactly what is happening. While auto-enrolment is an excellent idea in principle and a super example of the nudge theory working, with a 73% participation rate, it suffers from two defects.
Currently, anyone aged over 22 and earning £10k or more must auto-enrol and have their own pension pot. From April 2019, the individual must contribute 4% of their salary, while the employer needs to contribute 3%. The government will provide tax relief of 1%, making 8% in total.
The government is now proposing to reduce the threshold from £10k to £1 and the minimum age from 22 to 18.
Of course, it’s a good idea to encourage young people to save, but it’s far too blunt an instrument to make them save for a pension which is almost certainly not the best use of their money at that stage of their financial life. Given that the long-term saving return on a pension is 5%, it is highly likely that the amount of interest being charged on a loan, a charge card (and certainly a student loan) is above 5% – which is where the young millennial’s regular ‘savings’ amount should be redirected. Then there is the property to start saving for.
The downside in applying this logic is that people are not universally logical and need some nudging. They may not be as disciplined in pouring money into the pension scheme when they would rather go on a cruise. However, fortunately we live in a democracy rather than an autocracy, so as the Government is doing with its other pension reforms, trust the people.
Perhaps the biggest flaw in the system is to link both the employer and employee contributions together. Currently, if the employee doesn’t qualify for auto-enrolment and therefore contribute, then the employer doesn’t have to do so either.
What is needed is the employer to be required to make their contribution, currently 3%, regardless of the age or earning level of the employee, and this should not be linked in any way to the employee’s contribution. Equally, the employer’s contribution should not be capped in the other direction, whereas it is currently limited to paying 3% on an employee’s salary level at just one and a half times the average salary, ie £45,000.
If this defect can be rectified, then having the certainty of an employer’s contribution means that an individual can focus their savings more logically and flexibly. They may want to opt out immediately, focusing on the other financial essentials, but increasing their contribution rate as their financial circumstances change, especially as their disposable income may increase towards the later years. Such a tailored approach can yield a bigger return.
Sam and Alex
With the employer paying a flat 3% on all earnings, and assuming the long-term return is 5%, then let’s look at the effect of the change on two hypothetical people, Sam and Alex, with a starting salary of £16,000 when they are both 18, which continues to increase modestly so they earn £40,000 when they are 40 and £60,000 when they are 60.
Sam pays a fixed 4% of salary from his first day at work, aged 18 until age 60. The value of the pension pot is then worth £395,000.
Alex doesn’t make a single pension contribution until the age of 35 – some 17 years later than Sam, when Alex then contributes the same amount as Sam, 4%. However, from the age of 45, Alex then increases the contribution rate to 8% of earnings for five years before increasing again at age 50 to 12%. At age 60, Alex’s pot is £408,000 which is £13,000 larger than Sam’s £395,000. Sometimes, hares win over tortoises.
Views expressed in this article are those of the author alone and do not necessarily represent the views of the CISI.