Auto-Enrolment a bad idea about to happen

As the Minister for Social Protection, Heather Humphreys T.D., announced last week, the commencement of auto-enrolment is about to happen. Having reviewed some key design features of the proposed Automatic Enrolment pension scheme, our analysis suggests that Automatic Enrolment:

1. Represents poor value for money.

2. Is not the most efficient way to provide retirees with a socially acceptable standard of living.

3. Has little to no financial benefit for the State in the short to medium term.

4. Could result in financially vulnerable people missing out on qualifying for means-tested benefits upon retirement;

5. Can only reduce the "financial burden" of pensions on the State if the long-term plan is to reduce the value of the State Pension over time and force people to rely on their private savings.

Automatic Enrolment (AE) is a long time coming. Mooted around a decade ago as a 'solution' to low private pensions savings and coverage rates in Ireland, it was included as a key pillar in the Government's Roadmap for Pension Reform which was published in February 2018.

Last week's announcement set out some of the key design features of the scheme. They include the following:

• Current and new employees aged 23 to 60 will be automatically enrolled in a pension scheme where their earnings exceed €20,000 per annum. Those in that age category earning below €20,000 per annum will have the option to join voluntarily.
• The system will be "voluntary", but will operate on an ‘opt-out; rather than an ‘opt-in’ basis. Eligible employees will be automatically enrolled/ ‘opted-in’ but will have the choice after six months participation to opt-out or suspend participation.
• While there will be a choice of three funds in which to participate, people who do not express a preference for any fund will be enrolled into the default fund selected by the employer.
• Contributions will begin at 1.5% of earnings, increasing by 1.5 percentage points every three years to a maximum contribution of 6% after 10 years. Employers are required to make a matching contribution on behalf of the employee. Matching contributions will be made by employers to those contributions made by employees up to a maximum of €80,000. 
• The State will also top up contributions by €1 for every €3 saved by the employee, up to a maximum of €80,000. 

Why Automatic Enrolment?

Typically, the argument in favour of AE revolves around the need to encourage retirement savings, while the arguments most often cited as to why we would want try to incentivise pension savings usually revolve around two strands:

1. The need to ensure a reasonable continuation in the standard of living of people once they retire, reducing people’s reliance on the State in retirement;
2. The need to reduce the long-term financial burden on the State.

Let’s look at both of these in turn.

1. Maintaining living standards in retirement

This sounds like a fine idea. Indeed, back in 1998 the Pensions Board’s National Pensions Policy Initiative set a target of ensuring that a combination of pensions from all sources (State and occupational or private pensions) were adequate to cover 50 per cent of an individual's pre-retirement income. 50 per cent is an arbitrary target, but for now let's work on the basis that it is a sensible one.

A 2014 study by Collins and Hughes found that taking the median contribution to a private pension - calculated by them to be €3,300 per annum - as an example, contributing to a pension plan for 40 years will provide an annual income in retirement of approximately €5,200. Combined with the prevailing State Pension, this gave a replacement rate in 2014 of 37.5 per cent for a median pension contributor. So the median contributor should be expected to achieve about 75 per cent of the target. Is this a problem?

Research by TILDA indicates that retirement income replacement rates were not associated with quality of life after retirement. Instead they found that it is actual income in retirement, rather than the proportionate change in someone’s income from that received before retirement, that most affects quality of life. TILDA found that all aspects of quality of life, including control, autonomy, self-realisation and pleasure, increase consistently with household income. That's actual income, not proportions of previous income. This would suggest that policies aimed at achieving a certain rate of replacement to pre-retirement income should not be given as much priority as policies seeking to achieve a minimum income floor for retirees – something that the State Pension is best positioned to provide.

It's also worth noting that research by the ESRI - a micro-macro economic analysis of pension auto-enrolment options - points out that the relationship between the conventional earnings replacement rate and continuity in living standards is relatively weak and suggests an examination of the sensitivity of replacement rates to things like:

• net income (rather than gross);
• differences in housing costs before and after retirement;
• changes in household size and composition before and after retirement.

The study also suggests looking at in-work earnings over a longer time period leading up to retirement (rather than taking final earnings as a snapshot) as a way to get a more realistic picture of the pre-retirement income situation.

With all this in mind, and given that the purpose of any country’s pension system is to allow older people to retire from work with dignity, it would make sense that the vast majority of resources within the system be allocated to providing a flat-rate universal pension to all those over the State Retirement Age, and maintaining it at a level which allowed retirees to achieve what might be considered a socially acceptable standard of living. Social Justice Ireland has costed just such a proposal. Read more about it here.

2. The need to reduce the burden on the state

This is the argument most often cited in favour of AE and other incentives to increase private pension savings. We’ve heard it in different forms, but it usually sounds something like this:

• The number of older people in our society is increasing.
• The ratio of workers to pensioners is going to decrease significantly in the coming decades.
• As a result, the cost of paying the State Pension to those past the State Retirement Age will become unsustainable.
• Automatic Enrolment is part of the strategy for reducing this burden on the state and the best way to ensure people save for their retirement.

This sounds very logical, until you examine it further.

One of the features of the Irish State Pension is its connectivity to the labour market. Eligibility for a pension from the State is based on one of two strands:

• Social insurance contributions (PRSI);
• Means testing.

In other words, you qualify for a State Pension in Ireland on the basis of your labour market history and payment of social insurance contributions, usually over several decades, or you qualify based on a means test that shows that you do not have the financial means to provide for yourself in retirement.

In theory, encouraging people to save for retirement will help reduce their reliance on the State and therefore the financial burden to the exchequer of paying these pensions will be reduced. But here’s the thing…

Saving for a pension is expensive. As a rough rule of thumb, every €25 saved will buy a pension of about €1 per annum for a man aged 66 (the current State Retirement Age). And that’ll be a flat pension which will not increase, even though the cost of living will almost certainly increase over time.

People who can afford to save sufficient amounts of money over a long period of time to buy themselves a decent pension are almost always in the labour force for several decades, so are almost always the same people who will qualify for a full - or close to a full - State Pension (Contributory) based on their PRSI history. They will also have received thousands of euros – indeed more likely tens of thousands of euros – in tax relief (or whatever the State incentive under AE will be) over many years.

This is allegedly with a view to saving the State money when they reach retirement. But the fact that they may have saved a medium-to-large pension pot and so can afford a decent annuity will not reduce the cost to the State. On the contrary, these same people will now likely qualify for a full State Pension as well, assuming the qualification criteria for the State Pension does not change drastically in the meantime.

Yes, the individuals involved will be reasonably well off, and certainly much better off in retirement than had they not saved: they will have their State Pension (Contributory) – currently just over €13,000 per annum – and whatever money they are receiving from their private pension which was semi-funded by other taxpayers through the generous system of tax relief currently being implemented. But let's be clear: the saving to the State is exactly zero.

How about those who receive a means-tested pension; the State Pension (Non-Contributory)? By definition, they have not qualified for the State Pension (Contributory) due to insufficient PRSI payments, nor have they the necessary financial means to achieve a decent standard of living in retirement. Given that they have insufficient PRSI contributions, it’s safe to assume that their connectivity to the labour market over the preceding decades has not been particularly strong. They were therefore, for the most part, not in a position to avail of the tax-based incentives currently in operation, or to join pension schemes as part of the AE process.

Here, the incentivisation of private pension savings - whether through the current regime or through AE - has produced little saving for the State among this cohort, who are now in receipt of the State Pension (Non-Contributory). There may be situations where such people can contribute sporadically to AE schemes over the periods of time where they are in employment. However, research would suggest that people with such precarious links to the labour force tend to be in low paid employment, and so are prime candidates to opt-out of AE due to affordability issues, while what little money they are able to save may end up being counted against them when applying for a means-tested pension upon reaching the State Retirement Age. In such a case, there would be a saving to the State, but it would be a minimal one and may come at a significant cost to the living standards of some of Ireland's poorest.

While the State incentive of an additional €1 for every €3 contributed by the employee to the scheme, the distribution of private pension savings and the associated reliefs is such that more than 70 per cent of the relief granted to private pension contributions accrues to the top 20 per cent of earners and that the cost of all pension-related tax reliefs and exemptions runs into the billions of euros every year. AE will see this increase this by hundreds of millions of euros each year, with the final number unknown until we know the exact format of the incentive.

Social Justice Ireland has been pointing out for years that State incentives to save in private pension schemes are an expensive means of subsidising retirement savings for the better off in society, with little or no financial benefit to the State. The cost to the State will only continue to balloon with the implementation of AE, at a time when the almost 20,000 extra people are qualifying for the State Pension every year, and the increase of €5 in Budget 2022 was wholly inadequate, particularly in light of cost of living increases.

Yes, it should be acknowledged that, given that pensions are taxed in retirement, the exchequer will receive money back at some point. However, a significant proportion of those who receive relief at the higher marginal rate (currently 40 per cent) will pay tax in retirement at the lower standard rate (currently only 20 per cent), while many – regardless of which rate they received the relief – will have retirement incomes so low they will pay no tax at all.

The arguments in favour of Automatic Enrolment do not stand up. There is little to no fiscal benefit to the exchequer in either the short or the long term, unless the eventual aim is to slowly erode the value of the State Pension over time and force people to rely on their private pension savings - something that should be strongly opposed.

A better use of the resources would be to direct them towards funding a flat-rate universal pension payment from the State that would ensure that older people can retire with sufficient income to live life with dignity and without the prospect of exposure to poverty in their retirement.

Social Justice Ireland has proposed a universal pension for Ireland on several occsaions in the past. You can read more about it here.