July 24
Plugging the adequacy gap

The International Longevity Centre UK have released a new report entitled “The Global Savings Gap” which assesses pension systems in 30 developed countries in two main areas – “adequacy” and “intergenerational fairness”. The report raises a lot of interesting points, especially when considering how pensions might be funded in the long term. This blog considers the adequacy points for the UK in particular.

The report defines adequacy to be a 70% replacement ratio. This means that for a pension to be ‘adequate’, it must give a pensioner an income in retirement worth at least 70% of the income they enjoyed before retirement.

The bad news

The report finds that the average UK citizen needs to save 18% of their annual earnings in order to have an adequate retirement income after allowing for the state pension. This percentage is defined in the report as the ‘adequacy gap’. At a first glance, this result appears to show that comparatively the UK does terribly on the adequacy measure, with the percentage of earnings that must be set aside voluntarily to be the highest in the study. This can be seen in the graph below, labelled Figure 8, which is taken from the report.

Figure 8.png

The good news

However, concentrating on this graph alone misrepresents the overall picture because of the different pension systems operating in each country. Aside from the state pension which is funded from general taxation, in the UK pension saving is largely voluntary. This is not the case in many other countries in the study, several of which combine state provision with additional mandatory saving. When voluntary savings are included the adequacy gap in the UK falls to around 4% for the average person. This is shown in the graph below, labelled Figure 9.

Figure 9.png

After allowing for total pension savings, which allows for differences in how pension systems are arranged between countries, the UK therefore appears in a middle-of-the-road type position, even erring on the side of better-provisioned countries.

More bad news

Unfortunately, this does not mean that all is well in the UK. The following graph, labelled Figure 22 and taken from the report, illustrates two problems which are likely to arise in future.
Figure 22.png 
Problem 1: The average adequacy gap of 4% only takes into account those who make voluntary savings. The graph above, labelled Figure 22, shows that although the proportion of employees in the UK saving into a workplace pension has increased over the last 5 years or so, the number is still only just over 60% of the whole working population. Although it is possible that some people may be saving into individual pension arrangements which are not provided through the workplace, the numbers nevertheless suggest that a significant proportion of the population may not have any voluntary savings. The average adequacy gap for the whole population is therefore likely to be greater than 4%.
Problem 2: The average adequacy gap of 4% for those that do engage in voluntary saving includes a significant number of people with defined benefit pensions. According to the report, the average annual contribution to a defined benefit scheme is over 20% of earnings, whereas the average annual contribution to a defined contribution scheme is under 5% of earnings. These figures include both employer and employee contributions. Given the current trend of closing defined benefit schemes and offering only defined contribution schemes, the adequacy gap is likely to worsen over time. In particular, it should be noted that the average contribution currently made to defined contribution pension schemes of 5% is well below the 18% that the report says is required.
In conclusion, the study emphasises that the UK system gives individuals a high level of personal responsibility when it comes to saving for retirement. It appears that at the current time this responsibility is taken seriously, and the adequacy gap is broadly in line with that seen in similar countries. However, the death of defined benefit pension schemes means that this is far from guaranteed to continue into the future, and that young people today may have to make some difficult financial choices if retirement standards are to be maintained.

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