The economic impact of higher contributions

One of the key elements of proposed auto-enrolment reform is raising the current statutory minimum level of contributions from 3% for employees and 5% for employers.

While it is widely accepted that higher contributions will contribute to better retirement outcomes, what would the wider economic impact be?

This is the question addressed in a new paper, published last week by Royal London and Oxford Economics, an economic research and analysis firm.

The research modelled three contribution scenarios, each equally split between employees and employers: 10%, 12%, and 14%. The middle of these was the “central scenario”, and each case contributions were raised incrementally by 50 basis points a year. Adequacy assessment was based on the Pensions and Lifetime Savings Association’s retirement living standards.

Jamie Jenkins, director of policy at Royal London, told Pensions Expert that the research was not designed to be “a set of policy recommendations”, but instead to lay the groundwork for further informed discussion of the impacts of higher contributions and the “policy levers” that can be used.

Jenkins continued: “As someone who has been involved in pensions and retirement all my working life, I’d love to say it’s an easy fix that benefits everyone immediately. But clearly there are trade-offs and we need to consider these – this research is about starting that debate. It’s about getting an honest appraisal of what the challenges are and what the opportunities are.

Positive and negative effects

While overall the higher contribution rates all contributed to stronger economic growth under Oxford Economics’ modelling, the researchers also highlighted positive and negative impacts on businesses and pension savers.

For instance, higher statutory employer contributions were likely to lead to companies seeking to pass on these costs, either through higher prices or lower wages. This could in turn impact the amount of tax revenue for government.

However, higher contributions were also expected to result in people having more disposable income when they reach retirement. More assets in pension schemes also meant more assets that could potentially by invested in UK businesses.

This latter factor resulted in higher UK economic output in under all three scenarios at the end of the forecast period. The model ran from 2025 to 2040, and while economic output was negatively affected in the short term, in each case it was higher in 2040 than the model’s baseline scenario, which was based on no changes to pension contributions.

If contributions were to rise to 6% for employers and employees, the research estimated that average annual gross domestic product would be £1.6bn higher than the baseline scenario.

Affordability

Only 40% of UK households with defined contribution savings are expected to reach a “moderate” living standard in retirement, Oxford Economics stated in its paper. While higher contributions could go some way to addressing this – as well as boosting the economy through increased investment – there were “trade-offs” that needed to be addressed.

Oxford Economics acknowledged that, while higher contributions would likely raise overall retirement living standards, not all households would be able to afford to contribute more to their pensions.

In the 14% combined contributions scenario, the higher pension payments would account for more than 11% of “easy-to-access savings” for those in the lowest 20% of earners, the research stated. It meant that the 10% scenario, while bringing less of a positive impact to retirees overall, may be more affordable for those on the lowest incomes.

“This shows the delicate balance involved in raising pension contributions and suggests that a blunt solution such as a uniform increase in pension contributions for all individuals may not be appropriate,” the Oxford Economics report said.

“Indeed, the PSLA indicates that the state pension largely covers the amount required for a minimum standard of living in retirement. Therefore, a more carefully designed policy, which pays particular focus to addressing affordability issues for the poorest households, could help to ensure pension contribution reforms broadly achieve their objective (a higher overall rate of pension saving) – without creating short-term liquidity pressures for the poorest households.”

Jenkins added that housing costs and qualification for benefits were also factors to consider when changing contribution rates for the lowest earners.

He added: “We are not suggesting that contribution increases should start right away – we know it’s not the right time. But we need to have that debate and start planning for the future, or we could still be decades away from making changes that then take decades to play out. That’s too long.”

The PLSA has thrown its weight behind the move to raise minimum contributions to 12% in its ‘Five Steps for Better Pensions’ campaign, launched last year. However, it has proposed a split of 4% from employees and 8% from employers, in part to minimise the impact on lower earners. It also highlighted other tools such as emergency savings pots and temporary opt-out facilities may also help low earners with affordability.