When is the best time in your working life to save for retirement? We often hear that it makes financial sense to start saving at a young age.
The earlier you start investing for your retirement, the more time that money has to grow. And compounded investment returns work best when they have plenty of time to work.
But a more common experience of retirement saving is to wait until later in your career, when the opportunity arises to contribute more substantial amounts of money into your pension pot.
It is typical to see our income rise as we get older, as age and experience command a higher salary or earnings potential. Combined with having less expenditure when the kids leave home and mortgages are repaid, the opportunity to make much more significant pension contributions tends to arise in the decade or so before retirement.
New research from the Institute for Fiscal Studies (IFS) notes that workplace pension automatic enrolment does not currently encourage contribution rates that increase with age.
The IFS is calling for the Government to consider future adjustments to automatic enrolment that would encourage more retirement savings. Policies might include default employee contribution rates that increase with age, increasing contribution rates when earnings increase, and behavioural nudges to encourage savers to up their contributions when children leave home or they finish making debt repayments.
The study is part of an ongoing work funded by the Nuffield Foundation, based on an economic model used to illustrate how people might be expected to change their savings rate in response to predictable factors.
While this economic model is a simple approximation of real life, it does lead to some important conclusions that could guide real-world policies.
A key finding of the report is that if earnings are known to increase with age, then earnings growth and the costs associated with children would be expected to lead people to delay the majority of their retirement savings until older ages.
This delay in retirement savings would most likely happen until after children have left home when associated expenses fall.
If employers make pension contributions only if people also save for themselves, then employees would be expected to save throughout working life, but in low earning years only at the minimum levels required to obtain the employer contribution.
On this basis, savings rates would still be expected to rise significantly at older ages, especially when the costs of children living at home fall.
If the uncertainty of future earnings were factored into retirement savings strategies, it would lead to more savings happening earlier on in life. But higher contribution levels when household expenses fall later in life remains relevant.
For graduates with outstanding student loan debt, retirement savings would be expected to increase by the full amount of their previous loan repayments once student loans were repaid or written off.
The IFS thinks that policymakers should carefully consider life cycle factors when developing policies designed to increase retirement savings. They want policymakers to create policies that increase retirement savings at the most appropriate time in people’s lives.
The report findings also highlight one of the downsides of defined benefit (final salary) pension arrangements, that have contribution rates set by scheme rules, which cannot be varied to suit individual circumstances or timing of capacity to save.
A lack of savings flexibility is an often-overlooked cost associated with public sector pensions, likely resulting in many young people in the public sector saving more for retirement than they would ideally like to at an earlier stage in their lives.
Rowena Crawford, an Associate Director at IFS and one of the authors of the report, said:
“There are good reasons why individuals should not want to save a constant share of their earnings for retirement over their entire working life. This does not make automatic enrolment, with its single default minimum contribution rate, a bad policy.
“But as policy makers consider how to increase retirement saving further, focus should be on policies that increase retirement saving at the best time in people’s lives rather than just increasing saving irrespective of their circumstances.
“Default minimum employee contributions to workplace pensions that rise with age are an obvious option. A smart, joined up, approach across Government could also involve employee pension contributions rising when an individual’s student loan repayments come to an end.”
Alex Beer, Welfare Programme Head at the Nuffield Foundation said:
“This important analysis demonstrates how people’s ability to save can change as they age, as their earnings grow, and as their family circumstances change. Policies to optimise pensions saving might therefore take a more holistic view of saving across the life course, to consider when and how to capitalise on opportunities to change the rate at which people save.”