Will replacement ratios continue to be useful post pension reforms? Rachel Vahey investigates.
The shockwaves following the introduction of pension freedoms are still being felt, and will, I expect be with us for some time. The new way of accessing retirement income – whatever and whenever you want – means throwing out of the window a certain amount of what clients and advisers traditionally know about pension saving.
The PPI raised the question of whether more people will purposefully get into debt in later working life (or even early retirement) in the sure knowledge that they can use their pension funds to pay it off.
Take replacement ratios. For years now, governments and a large proportion of the pensions industry have been relying on this method as a way of measuring how wealthy (or not) our pensioners are. The replacement ratio is the retirement income shown as a percentage of working income needed to replicate the same standard of living the person had in working life. Over the years, replacement ratios have been cited as evidence for tinkering about with pension legislation – the Turner Pension Commission is probably being the best-known adopter of this approach, the reports are littered with references to replacement ratios.
But now – in sunny 2015, post pension freedoms – how useful are replacement ratios? That was the question posed by the Pension Policy Institute (PPI) in its recent briefing note. Reading the briefing note just confirmed what I suspected – that measuring pensioners’ wealth is in practice far too complicated to condense down to a single percentage or ratio.
The beauty of pension freedoms is people’s hard-saved pension money can be used in the best way for them. And for a significant number of people that is paying off debt. The PPI highlighted the number of over 50s who have any type of debt has fallen in the last few years. But still 32% - one in three – are in debt. And the median average amount of that debt has increased to £12,000.
Replacement ratios ignore debt. So, back in the day someone might have had a replacement ratio of, say, 80% but also a £20,000 debt. Now, they might choose to repay the debt with their pension savings, reducing their replacement ratio, and so, in a simplistic world, becoming worse off financially in retirement. But of course they’re not, as their debt has been paid off.
The situation could become more confused if the introduction of pension freedoms leads to, as some have suggested, greater consumer debt. The PPI raised the question of whether more people will purposefully get into debt in later working life (or even early retirement) in the sure knowledge that they can use their pension funds to pay it off.
There has always been an element of that with pension savings – many people have had their eye on the 25% tax-free cash as a source of debt repayment. And, of course, there was, back when I was a pensions youngster, a whole stream of promotional pensions planning that used the tax-free cash lump sum to pay off the mortgage. What is interesting is questioning whether this will increase as a result of the new freedoms. I rather think it will. People will be more aware of the pension fund, and some may spend it before age 55, either on specific projects or just on life and keeping heads above financial waters.
So, is replacement ratio evidence is worth anything to the policymakers? The problems with using a simple single measurement have always been there, but the introduction of pension freedoms has just shown what a fraud it can be. Replacement ratios will probably fall under the new regime – but why that is the case may be unknown. It could be a result of people paying off debt using pension income, and in reality the total sum of their wealth (taking into account assets and debt) probably hasn’t changed. Or people have taken on more debt or frittered away their pension income on other things, and so become poorer in retirement. Or people have not saved as much and simply have less money in retirement.
It looks to me like replacement ratios will not be a reliable source on their own, and only form one strand of how we can judge how wealthy our pensioners are.