ANNEX
IMPLIED
RATE OF
RETURN ON
SAVING
The charts show the implied rate of return on
saving for an individual saving £50 a month for different
lengths of time under different pension systems. The implied rate
of return is calculated by comparing the amount saved with the
increase in total income in retirement (taking account of the
impact on income from means-tested benefits) generated by that
saving. The higher the implied rate of return, the greater the
economic benefit from saving. A negative implied rate of return
suggests that saving in fact has a net cost to the individual—
less value is received in increased retirement income than is
paid in through contributions.
The charts show that:
- Under the current Minimum Income Guarantee
(MIG) system, saving for even relatively long periods of time—up
to 20 years—is not worthwhile. This is because MIG is withdrawn
at a rate of £1 for every £1 of income from saving,
resulting in an implied rate of return of (¸100%)—saving
does not increase income in retirement at all.
- Under the Pension Credit (PC) as outlined
in the State Pension Credit Bill, saving is more worthwhile for
those saving for short periods of time than it is now, but the
implied rate of return is still negative for more than 10 years.
This is because any saving results in a reduction in income from
MIG and Pension Credit of 40p for every £1 of saving income.
- If the first £10 of income from
saving is disregarded from the Pension Credit calculation[6]—so
there is no withdrawal in benefit until saving income exceeds
£10—the value of saving is greatly enhanced for those
saving for only short periods of time. Because there is no immediate
reduction in benefits, these savers obtain full value from the
tax relief and means-tested benefits available to them.
Chart 1: Implied Rate of Return on Pension
Saving of £50 a month, Current MIG System, for an Individual
Retiring in 2025
Chart 1 shows that, under the current MIG system,
this individual would have to save for 29 years to see a positive
rate of return on their contributions. They need to save for at
least 22 years to see any reward at all for their saving.
Chart 2: Implied Rate of Return on Pension
Saving of £50 a month, Pension Credit System, for an Individual
Retiring in 2025
Chart 2 illustrates the implied rate of return
for the Pension Credit as outlined in the State Pension Credit
Bill. Although the return on contributions is much higher for
those saving for short periods of time compared to the existing
system for this individual, they would still need to save for
at least 12 years to get a positive rate of return.
Chart 3: Implied Rate of Return on Pension
Saving of £50 a month, Pension Credit System incorporating
a £10 disregard, for an Individual Retiring in 2025
Chart 3 illustrates the impact of disregarding
the first £10 of income from saving when calculating the
Pension Credit. Because benefit income is not reduced for small
amounts of saving, and through the availability of tax relief
for pension contributions, if this individual saves for only a
small length of time the rate of return is high. Even when Pension
Credit and Minimum Income Guarantee is withdrawn as the income
from saving increases, the return on saving remains significantly
positive.
ASSUMPTIONS
FOR CHARTS
Inflation of 2.5%, nominal earnings
growth of 4% and nominal returns on investments of 6%
Annual Management Charge on pension
fund contributions of 1%
An annuity rate of 8.5%
Tax Relief on pension contributions
is assumed at 22%.
The individual receives a full Basic
State Pension. If the individual receives less, the initial implied
rate of return on saving under the State Pension Credit Bill reverts
to that obtained under the current system i.e. an initial rate
of (¸100%).
The Individual is assumed to retire
at age 65. If they retire earlier (for example a woman retiring
at age 60), the implied rate of return on saving under the State
Pension Credit Bill reverts to that obtained under the current
system i.e. an initial rate of (¸100%).
No income is assumed to be received
from SERPS, S2P or contracted-out equivalents. Although in reality
most individuals will have income from these sources, that may
increase the value of saving (and reduce the number of years where
the implied rate of return is negative), some—and especially
the self-employed—may not have income above the Basic State
Pension.
The components of the Pension Credit
and Minimum Income Guarantee are assumed to be increased each
year in line with the growth in earnings (including the £10
disregard assumed in chart 3).
The charts only take account the
impact on the income received in the first year of retirement.
If, over time, income from saving grows less quickly than Pension
Credit and Minimum Income Guarantee, the increase in total income
due to savings is reduced. This will reduce the value of saving
(reduce the implied rate of return).
No allowance is made for Housing
Benefit and Council Tax Benefit. These would tend to reduce the
increase in total income due to saving as benefits are withdrawn
as income increases, and so further reduce the value of saving
(lower the implied rate of return).
Contributions are assumed to be made
in the years immediately before retiring. So someone saving for
one year begins at age 64, someone saving for 10 years begins
at age 55.
6 For more information on this option please refer
to the ABI response to the PC consultation document. Back
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