Pension Models

At this point, it is worth making some comments about the 4% pension contributions indicated in the model, which is linked to the proposed UK pension scheme called  NEST, i.e. National Employment Savings Trust. While this scheme will not be fully operational until 2017/18, we might consider the following table as representative of a future ‘minimalist’ pension plan, although employees can still opt-out if they wish. In terms of our model, both partners have elected to go with the 8% minimum required by the scheme, which requires a 4% employee contribution, as outlined in the table below:

Employee Employer Government Total Years Annuity
4% 3% 1% 8% 40 20
£1,060 £795 £265 £2,120 £84,800 £4,240

At first glance this may appear to be a ‘good deal’ as the employee contributions have been effectively doubled. However, the scheme only requires the employer to put in 3%, irrespective of the employee contribution, and concerns have already been raised that some small businesses may put ‘pressure’ on their employees to opt-out. However, there is a more fundamental question that needs to be considered:

How much pension will 8% provide?

If we simply assume that the pension pot will keep pace with inflation, its value on retirement after 40 years will be £84,800 in today’s money, which sounds a reasonable amount until you amortise this sum over 20 years of retirement, i.e. £4,240/year. This works out at 5%, although it is unlikely that this rate will be realised through a pension annuity. More accurate figures regarding the pension pot and annuity are discussed under the heading 'pensions' within the final 'closing comments' discussion.

How might we compare the disposable income in retirement to the model above?

The originally the disposal income, before retirement, was calculated by deducting tax and national insurance plus the pension and mortgage cost from the salary, after which the household costs could be met, e.g.

Original Disposal £14,224 £14,224 £28,448 100%

However, in the table below, income is now based on the state pension plus an 8% NEST pension, as outlined above. While tax still has to be paid on income over the current £10,000 threshold, it can be seen that the revised net income of each person in this model hardly exceeds this threshold and so is ignored. As such, the net income is effectively the sum of the UK state pension and any pension annuity derived from the final NEST pension pot after 40 years. Therefore, in this case, the ‘net income’ is equivalent to the original ‘disposable income’  of the model above and can be compared directly:

Item Person-1 Person-2 Combined %
State Pension £5,880 £5,880 £11,760 41.3%
Pension Annuity £4,240 £4,240 £8,480 29.8%
Net/Disposal Income £10,120 £10,120 £20,240 71.1%
Household £11,503 £11,503 £23,005 80.9%
Balance -£1,383 -£1,383 -£2,765 -9.7%

So, by normalising all amounts to present-day values, it appears that the revised net/disposal income in retirement falls to 71.1% of the original disposal income prior to retirement. While we can see that the ‘balance’ is not enough to cover the ‘ household costs’ , it would appear that the retirement income is actually in excess of 2/3 of the disposal income prior to retirement. However, if we reference back to the introduction of pensions , it was stated that historically ‘defined benefit (DB)’ pensions were said to provide a 2/3 (66%) final salary after 40 years service, such that we might think that ‘defined contribution (DC)’ pension implied in the table has provided something comparable. However, the real different in retirement income between the 'DC pension' scheme above and a historic 'DB pension' scheme is better illustrated below:

Item Person-1 Person-2 Combined %
Gross Income £26,500 £26,500 £53,000 100.0%
2/3 DB Pension £17,667 £17,667 £35,333 66.7%
State Pension £5,880 £5,880 £11,760 22.2%
Tax £2,709 £2,709 £5,419 10.2%
NI £0 £0 £0 0.0%
Net/Disposal Income £20,837 £20,837 £41,675 78.6%
Household Costs £11,503 £11,503 £23,005 43.4%
Balance £9,335 £9,335 £18,670 35.2%

As such, both partners would have received 2/3 of their final gross salary on retirement plus their state pension. While this income would be subject to tax and tax relief, no NI is paid after the normal retirement age. Therefore, their ‘net income’ based on a DB pension is 78.6% of their original gross salary, while the ‘net/disposal income’ based on the minimal NEST DC pension is only 38.1%.

So what caused the shift away from DB to DC pensions?

In practice, there are a lot of reasons cited as contributing causes to the demise of DB pensions in favour of DC pensions, which the note below only summarises. However, one possible reason that is not cited in this list, which might actually be the most compelling from the employers perspective is that DC pensions transfers all the financial risk, and responsibility, onto the employee.

Note: As indicated above, there are many possible reasons cited as to why pension fund surpluses, originally associated with DB pensions, evaporated and led to the adoption of DB pensions, e.g. pension fund surpluses became subject to tax, additional costs were added to the DB schemes, the 1995 pensions act, removal of tax relief,  employer contribution holidays, employers diverting surpluses for industrial restructuring, trends to earlier retirement, increasing longevity, actuarial assumptions too optimistic, over-reliance on investments, lack of trustee management, falling stock markets, lower interest rates.

Now, the cynical might well want to point out that the 'employees' and the beneficiaries of the original defined contribution pension schemes probably took little to no active part in the decision making processes behind any of the reasons cited above, which then led to the demise of their pension funds. However, in fairness to the 'employers', the following examples might help illustrate the amount of money that has to be invested into a pension scheme in order to approximate even a 50% final salary pension.

Average
Salary
 Pension
Contributions
Working
Years
40 Year
Value
Retirement
Years
Final
Salary
Pension
100% 25% 40 1000% 20 50%
£26,500 £6,625 40 £265,000 20 £13,250

If we attempt to provide a comparison for the 8% NEST scheme being proposed in the UK and adopted by the model, we might see the shortfall that results in almost any DC pension plan.

Final
Salary
Pension
Contributions
Working
Years
40 Year
Value
Retirement
Years
Final
Salary
Pension
100% 8% 40 320% 20 16.0%
£26,500 £2,120 40 £84,800 20 £4,240

While we might wonder who, if anybody, was the beneficary of the change towards defined contribution schemes, we might guess that this was another 'opportunity' for the financial service industry. So while the NEST scheme requires a contribution from the employer, this is only mandated to be 3%, although the employee would get further tax relief on any additional pension contribution year-on-year. As an approximation, each partner in our model would have to increase their yearly pension contribution from 4% to 6.5% in order to cover their pre-retirement household costs. Of course, examination of the household cost in retirement might suggest several areas where additional savings could be made in retirement, e.g. only having 1 car could save £3,500 per year.

So, without an adequate pension, how will retirement be financed?

Clearly, those people in rented accommodation might have to continue to pay rent into retirement, which may incur a rent cost £10,000 per year for even a modest 3-bedroom property and then be subject to year-on-year inflation. Therefore, we shall now turn the attention on mortgage costs in the next discussion.