Encouraging factors suggest April’s increase in contributions will not lead to higher opt-out rates after all
The world of workplace pensions has been transformed in the past six years, but we are on the eve of a vital test as to whether this has all been an illusion.
The success of automatic enrolment to date reflects a huge amount of effort by employers, advisers, providers and a whole network of support services, and the results are impressive. More than a million firms have enrolled nearly 10 million workers into a pension.
This is a social and economic experiment on a scale barely without equal across government. Normally, policy is designed by economists on the assumption we are all rational economic men and women. But this policy is based on the fact we are not purely rational – our actions are affected by all sorts of unconscious behavioural biases.
In pure economic theory, whether you are put in a pension and have to opt out or whether you start outside a pension and have to opt in should make very little difference to the outcome. Yet the experience of auto-enrolment to date is that it makes a huge difference.
So far, roughly nine in 10 workers who have been enrolled have simply stayed enrolled, and for those enrolled when they join a new firm the staying-in rate is closer to 95 per cent.
When the Government set up this programme, it assumed roughly one in three workers would opt out. This assumption was based on asking people the hypothetical question as to what they “would do” if they were enrolled. As we know, they behaved very differently, which is perhaps not surprising given we are talking about “unconscious” behavioural biases.
But there is, of course, a nagging doubt in all of this. Has the success of auto-enrolment to date simply been because the mandatory contributions are so low? Will people start opting out in their droves once contribution rates rise, including a five-fold increase in employee contributions between now and April 2019?
There are very strong reasons to think that the number of people who will simply drop out of workplace pensions in April this year and next will be very low. The first is simply that inertia remains a wonderful thing. The same factors that led people to stay enrolled against their expectations when contributions were at 1 per cent remain in force when contributions rise.
While there could obviously come a time when affordability trumps inertia, it seems unlikely that, for most workers, an increase of a few pounds a week will be the tipping point.
For evidence on this we can look to the US, where a number of workplace 401(k) schemes have experimented with various ways of stepping up minimum contributions from low initial levels. The clear pattern is that when people are stepping up at low-single-digit levels of contributions, the cost is not enough to overcome the inertia of staying put.
The second reason for confidence is that the lowest-paid workers – who might be expected to be the most likely to opt out – will get a big pay rise in April. The National Living Wage (for those aged over 25) will rise by 4.4 per cent, with further increases planned in future years. This increase will be more than enough to absorb an increase in pension contributions at the level planned.
Apart from those on the NLW, many more people will see a routine pay rise in April. Although wage growth is currently running below the rate of inflation at around 2.4 per cent a year, this is still more than the 2 per cent rise in pension contributions workers will have to make, especially allowing for tax relief on those contributions.
On top of this, April is the time each year when the starting point for income tax and National Insurance contributions is increased, which leads to a small reduction in direct tax bills. Coupled with a routine pay rise, the large majority of auto-enrolled workers will still see a rise in their take-home pay in April, even after the deduction of increased pension contributions.
Given that few people will be able to (or will choose to) work out what their take-home pay would have been without the pension change, there is every reason to expect most will take this increase in their stride.
We should, of course, seek to communicate the changes effectively to make sure workers feel that they are in control of what is happening.
But remember that when auto-enrolment was first introduced, most workers saw an actual cut in their take-home pay – and yet 90 per cent stayed in.
As long as most people see a small rise in their take-home pay this April, I firmly believe we will be able to keep them in pension saving.
Steve Webb is director of policy at Royal London