How to avoid hidden pension trap

Pension reform is underway, but it’s only the first step along a long road to securing a comfortable retirement, writes Pádraig Floyd

The UK has little experience of revolution. When it happens, it tends to be technological or conceptual rather than bloody, though there have been some notable exceptions.

Yet the nation is undergoing the most significant social change since the introduction of the National Health Service after the Second World War. That revolution is the introduction of auto-enrolment (AE) and, even if you have managed to avoid exposure to this subject to date, you won’t be able to avoid it for very long. This is because AE compels every employer to enrol their workers (automatically, as the name suggests) into a pension scheme.

The aim is to introduce millions of workers to saving for a pension through the workplace for the first time. It is part of a series of reforms introduced to make saving for your retirement more rewarding for the individual and, as part of that package, there is a new and simplified basic state pension to be introduced in 2017.

This is said to do away with the disincentive to save that is caused by means testing of benefits, but the reality is somewhat different.

The £144 (in today’s money) on offer in 2017 is considerably more than today’s £107, but is very similar to what many already receive. It is also considerably less than the highest amount received by those who were fully paid up into what was Serps or S2P (second state pension). And unless the government changes the structure of key benefits, such as housing and council tax relief, pensioners will indeed see their additional retirement savings undermined by means testing.

If you’re 30, you need to save 15 per cent of your salary, at 40 it’s 20 per cent and so on

So, saving for your future remains of crucial importance unless you wish to be one of the cat food generation, but this message will be missed if people believe the headlines.

Just as reform to the basic state pension isn’t a panacea for pensioner poverty, nor is AE the cure-all for people failing to save through the workplace. It’s hard on the employer, for whom the record-keeping alone is a nightmare, but assuming employees do not opt out of the scheme once auto-enrolled, they are likely to believe their problems are over. They’re wrong, of course.

Politicians and the media tell us AE will deliver 8 per cent of salary into a pension scheme, split between the employee (4 per cent), employer (3 per cent) and the government in the form of tax relief (1 per cent). While 8 per cent is an accurate description, it won’t come about for some years as the rates are phased in slowly.

It also isn’t based on salary, but “band earnings”, an arcane and seemingly arbitrary calculation, which is considerably less than 8 per cent of salary.

There’s a rule of thumb that says if you haven’t started saving, you need to put away a proportion of your salary every month that equates to half your age. So, if you’re 30, you need to save 15 per cent, at 40 it’s 20 per cent and so on. And this won’t make you rich, only comfortable in old age, so 8 per cent of band earnings simply won’t be enough to live on.

However, the vast majority of workers will believe that once they’ve gone through auto-enrolment, they can cross pension off the list. It’s a dangerous trap to fall into as an employee, as you’ll get a nasty surprise when it is probably too late to do something about it.

But for employers, the reputational risk is limitless. Employers don’t have to do any more than the bare minimum, but who will employees blame if upon reaching retirement they discover the pension they’ve been saving into won’t stretch beyond a fish supper and a lottery ticket once a week?

Of course, everyone expects that, once established, contribution rates will be increased automatically. But while the government banks on inertia preventing people from exiting these schemes, misplaced faith in AE meeting all requirements is as likely to undo those grand designs.