Pensions & savings

Perfectly adequate?

Revisiting pensions adequacy 20 years after the Pensions Commission

Molly Broome
Molly Broome
Ian Mulheirn
Ian Mulheirn

In 2002, the Labour Government established the Pensions Commission to review the UK’s private pensions system and make recommendations for reform. Twenty years on from the Commission’s landmark first report, the auto-enrolment pension regime it proposed has finally come to fruition, revolutionising pension coverage in the UK. But alongside the rollout of this pioneering policy, the tax system and State Pension have undergone significant reform, and there have been huge swings in the economic and financial environment. These changes have crucial implications for whether pensions policy can provide an adequate retirement income.

So, the time is ripe to revisit pensions policy. This paper explores what we’ve learned since the Pensions Commission made its recommendations and considers what the changes of the past 20 years mean for pension adequacy. In doing so, we seek to frame some of the critical questions the new pensions review should address as it charts a course for the next decade of pensions policy.

Key findings

  • In 2004, the Pensions Commission established a set of gross income replacement rates that it deemed sufficient to smooth living standards between working life and retirement. However, significant shifts in the tax system have since narrowed the gap between tax paid during working life and in retirement, particularly for low-to-middle earners.
  • Under today’s tax regime a median full-time earner on £37,000 in 2024-25 sees their take-home pay reduced by 17 per cent due to Income Tax and National Insurance, compared to 23 per cent in 2002-03. At the same time, the tax paid in retirement has slightly increased.
  • These changes mean that today’s median earners need a 72 per cent replacement rate to achieve the same living standard that a 67 per cent rate would have provided twenty years ago.
  • The Pensions Commission projected that the combination of the State Pension and auto-enrolment would provide slightly more than a 45 per cent replacement for a median earner.
  • However, today’s regime under the prevailing economic and financial conditions look likely to provide a median earner with gross earnings replacement of around 51 per cent. This is above the Commission’s minimum policy goal of 45 per cent, but still a long way short of the updated target replacement rate of 72 per cent.
  • We estimate that contributions rates would need to rise above 14 per cent to put median earners on track to achieve the updated target replacement rates through formal pension saving. But such a change would push low earners well above their target replacement rate.
  • There are also other reasons why it may not be appropriate for policy makers to raise default contribution rates in pursuit of target replacement rates. Firstly, historical data shows that middle and higher earners typically fall short of the Pensions Commission’s target replacement rates, suggesting these targets are ambitious. Secondly, targeting replacement rates based on final earnings risks undermining the principle of smoothing living standards over a lifetime. Thirdly, many people have other financial resources outside of formal pensions to support their retirement.

Recommendations

We believe the Government’s upcoming review of pension outcomes should address four key questions:

  • First, it should clarify the purpose of auto-enrolment: is it meant to provide a baseline of savings, as the Pensions Commission proposed, or is it aiming to fully achieve target replacement rates? The new Government’s pensions review might consider articulating a full range of ‘adequate’ replacement rates for different income bands that policy could target to sit alongside the higher ‘optimal’ replacement rates represented by the target replacement rates, which could be left to individuals to pursue.
  • Second, the review should consider whether it is more appropriate for policy to benchmark against people’s average, rather than final, earnings when defining replacement rates.
  • Third, the review should consider whether the time has come for pensions policy to be designed to help balance the twin objectives of retirement and precautionary saving rather than pitting them against one another. A better system would allow constrained flexibility for people to tailor contribution rates to need and greater liquidity for savings to be used for precautionary purposes.
  • Finally, the review should grapple with the question of risk. In a world where defined contribution pensions are now the dominant model, two key assumptions are particularly uncertain: the rate of return on investments in working age and the annuity rates that might prevail at the time of a person’s retirement. It is crucial to reassess how policy can address, or better help people to manage, these risks.

Further reading

Perfectly adequate?
Revisiting pensions adequacy 20 years after the Pensions Commission
·
Molly Broome, Ian Mulheirn
Calculating a Living Pension: the 2024 update
·
Molly Broome
Under triple lock and key
What would a ‘triple-lock-plus’ policy look like?
·
Mike Brewer, Alex Clegg
Molly Broome
Molly Broome Economist
Ian Mulheirn
Ian Mulheirn Research Associate