Twelve fixes to help the self-employed save for the future
Whether it is a result of cognitive biases, volatile earnings or a bewildering menu of financial products, many of the self-employed are not saving sufficiently for the future. But what would it take to turn things around?
By Benedict Dellot, Associate Director, and Fabian Wallace-Stephens, Data Researcher for Economy, Enterprise and Manufacturing at the RSA
Four pillars, twelve fixes
With a new report on pensions emerging every few months and multiple events dedicated to analysing the pension landscape, there are no shortage of ideas in circulation. However, the debate tends to be both shallow and narrow. Shallow in the sense that little consideration is given to whether a policy or practice proposal is affordable, fair vis-à-vis employees, or politically tolerable. And narrow in the sense that the overriding focus of thought leaders is on how to boost pension take-up among the self-employed, with less attention paid to encouraging them to save enough or make use of those savings appropriately in retirement. Moreover, rarely do reforms attempt to address the underlying causes of under saving, such as volatile incomes made worse by late payments.
In this chapter we take a step back and consider the full spectrum of potential interventions open to the government and financial industry. Twelve ideas are outlined in total, divided between four sequential steps of the saving journey: (i) saving something; (ii) saving enough; (iii) accessing savings before retirement; and (iv) accessing savings during retirement. These are summarised in Table 3 below.
1. Saving something
Pitting pensions against the Lifetime ISA
When the government introduced the Lifetime ISA (LISA) in 2017, the intention was to offer an additional financial product that would encourage people to save for the future. But it may have made an already puzzling financial landscape even more difficult to navigate. Indeed, it appears that pensions and the LISA have been pitted against one another as competitive products, leaving prospective savers confused and liable to make poor judgements. Consumer platforms including Which?, Money Saving Expert and Unbiased have all rushed to offer guidance on whether savers should steer towards a LISA or a pension. So how do they compare?
Table 3: The four pillars of retirement security
The LISA is open to all savers under the age of 40, and offers a bonus of £1,000 for every £4,000 deposited, up to a total value of £32,000. The savings can be accessed by account holders when they purchase a first home or at the point they reach their 60th birthday. The bonus is withdrawn if account holders want to access the LISA for any other purpose. The LISA is seen by some as well suited to the self-employed because all the savings are theoretically available should there be an emergency. Previous research by NEST has also shown that many people prefer ISAs over pensions because they are simpler to understand and involve fewer intermediaries. A 25 percent ‘bonus’ with tax paid on withdrawals is easier to make sense of than the complex tax rules underpinning pensions.
Yet pensions have a number of advantages for the self-employed. Contributions made into a pension receive tax relief set at the marginal income tax rate of the saver — either the basic rate of 20 percent for those earning up to £45,000, the higher rate of 40 percent for those earning above this amount up to £150,000, and the additional rate of 45 percent for anyone with a higher income than this. For the majority of people on the basic rate, this means they only need to contribute £80 to save £100 in a pension, with tax relief making up the difference. Basic rate taxpayers therefore accrue the same core tax advantage whether they save through a pension or a LISA. However, pension savers benefit from several additional perks, among them:
• A tax-free lump sum worth 25 percent of their pension pot.
• Access to their full pension pot at the age of 55 rather than 60 as
is the case with the LISA.
• No inheritance tax on their pension pot should they die before
the age of 75.
Beyond the matter of differing tax treatments, pensions have the added advantage of enjoying higher returns. Because the money is locked away for a lengthy period — often over several decades — pension fund managers are able to invest in more volatile assets, the value of which can rapidly rise and fall in the short term but grow significantly over time. In contrast, the Lifetime ISA is used both as a short and long-term savings vehicle, meaning providers are likely to take more cautious investment strategies and that final pot sizes will be smaller. Skipton, the only building society that offers a cash LISA, offers interest rates at a relatively meagre 0.75 percent per annum. Contrast this with the 10 percent return averaged by pension funds in 2017.
Overall the LISA comes across as an overstretched and confused financial product — a jack of all trades that attempts to do too much. Investing in a LISA does make sense for some groups of savers, particularly low earners (who stand to gain less from the various tax reliefs of a pension) and the self-employed with highly volatile earnings (for whom liquidity is essential). Yet it seems unwise, as some have advocated, to champion the Lifetime ISA as a potential replacement to a pension for the self-employed. As the ex-Pensions Minister Steve Webb argued in an interview with us, it would be better to improve upon the vast pensions infrastructure already in place than to start a new savings system from scratch. This could be achieved by introducing a degree of liquidity to pension products — an idea we explore later in the chapter.
In the meantime, the government should, as a matter of urgency, clarify its strategy for the Lifetime ISA, explain what value it is meant to add to existing pension provision, and ensure the new single financial guidance body supports savers to make an appropriate choice based on their personal circumstances.
Recommendation #1 — The government should clear up the confusion surrounding the Lifetime ISA by restating its purpose and value — The government should (i) clarify its long-term strategy for the Lifetime ISA; (ii) be clear on what it offers that existing pensions do not; and (iii) ask the new single financial guidance body to help savers understand whether it is the right product for them.
To auto enrol or not to auto enrol?
Assuming pensions are the right product for most of the self-employed, what is the best way of encouraging them to sign up? One solution is less to compel and more to ‘nudge’. Stalwarts of behavioural science have advocated extending auto enrolment to the self-employed, pointing to how it has radically improved pension coverage among employees. In the four years following its introduction, the proportion of employees signed up to a personal pension jumped from 49 percent in 2011/12 to 62 percent in 2015/6 — a figure that will grow further as smaller companies become subject to the regulation. It is too early to judge the full impact of auto enrolment, since the minimum contribution rates for employees are due to rise further, possibly leading to greater attrition. Yet it is impossible to deny the transformative effects of this policy.
Despite this, the government continues to give a lukewarm reception to the idea of bringing the self-employed under the purview of auto enrolment. The Auto Enrolment Review, published in December 2017, concluded that ‘there is no employer to automatically enrol the individual into saving and so we have considered and rejected the idea’. Rather confusingly, the Review then goes on to list several promises that could amount to a form of auto enrolment, or what some might describe as ‘assisted enrolment’. This includes the commitment to test whether banks could act as touchpoints that encourage the self-employed to save, and to explore whether organisations that use self-employed contractors (for example IT contractors or construction workers) can play a role in enlisting them onto a pension.
The government is right to be cautious in the short term, but it must be ambitious in its direction of travel. We urge the government to reconsider its stance on auto enrolment for the self-employed and take a lateral view on how this might be realised. Several variants of the employee model have already been aired. One of these is to nudge the self-employed with a ‘forced choice’ question, compelling them to decide — yes or no — whether they would like to sign up to a personal pension. The question could be presented to the self-employed at the point they complete their self-assessment tax return, with the information passed on to pension providers who could follow up separately. A Harvard University study into the use of a forced choice question at a US company found that pension enrolment rates grew from nine percent to 34 percent in the first four months of job tenure.
However, this approach arguably leaves too many gaps through which prospective savers might fall. Crucially, it depends on pension providers taking the action to follow up with the self-employed and agree a payment schedule. A different approach is to place responsibility for enrolment with accountancy software providers, such as Sage, Crunch and QuickBooks. In practice they could present the forced choice question to their self-employed users, who could agree to automatically deposit a given proportion of their profits every month to one of several pension plans offered to them. Unlike banks, who have an incomplete picture of savers’ finances, accountancy software providers understand both their revenue and expenses, and can increasingly estimate their tax liabilities too.
The government should follow through with the Review’s proposal to work with accountancy providers on these terms, and — depending on the outcomes of a pilot — consider creating a new duty for them to enrol self-employed clients onto a pension. The age and earnings thresholds at which this duty takes effect should mirror those for employees. The Auto Enrolment Review recommended that the criteria for enrolment be expanded to include 18–21 year olds, and suggested that pension contributions for participants be based on all their earnings rather than those above £5,876.[3] But the deadline for implementing these extensions — by the mid 2020s — is achingly slow. Moreover, the Review could have gone further by removing or reducing the £10,000 earnings trigger at which workers are signed up to a pension. We hope the government is open to reviewing the timeline and scope of its reforms.
Recommendation #2 — The government should reconsider its opposition to auto enrolment for the self-employed, and follow through with a proposal to view accountancy software providers as the ‘employer’ — The government should continue to review the options for auto enrolling the self-employed onto a pension, potentially through a ‘forced choice’ question. It should also proceed with an investigation to treat accountancy software providers as the de facto ‘employer’, with a duty to enlist their self-employed clients onto a pension scheme.
It is worth noting that gig workers who are classed as ‘workers’ in terms of their employment status may be entitled to auto enrolment, depending on their age and income. However, some people in this position may be unaware of this right, while the government may not have the resources to enforce the law.
A new pension passport
One idea routinely raised is to create a specific and bespoke pension product for the self-employed. The business group IPSE, for example, recently called upon NEST to create a ‘flexible pension solution for the self-employed, allowing them to withdraw the last two years of contributions without penalty’. We will return to the issue of liquidity later in the chapter, but the core idea of a product aimed squarely at the self-employed is problematic. First, there is a danger of giving the self-employed special treatment, which undermines fairness in the labour market and risks creating incentives for bogus self-employment. But more fundamentally, the idea fails to recognise the fluid boundary between the self-employed and employees, with many workers experiencing periods of both job types during their lifetime.
Helpfully, more data is emerging to give us a clearer idea of when people move into self-employment and how long they stay there. Analysis from the Department for Work and Pensions suggests the mean age at which people enter self-employment is 32. This suggests many have had previous experience working for an employer, and indeed other data bears this out. Looking at people with at least 10 years of tax records, the Pensions Policy Institute and Old Mutual Wealth find that the vast majority (75 percent) who had at least one year in self-employment had spent less than half their working age working for themselves. Just a fraction (four percent) had remained in self-employment across all the 10 years analysed. What is more, for 90 percent of those who had experience of both types of work, employment occurred before the first spell of self-employment.
The implication is that a large number of people in self-employment today are likely to have workplace pensions built up during a previous period working for someone else. The Pensions Policy Institute say this could be true for as many as 500,000 of the self-employed. A potentially transformative intervention therefore could be a ‘Pensions Passport’ system, which would enable the newly self-employed to carry over a pension from a job they have recently left. The establishment of the new Pensions Dashboard will make it easier to track one’s pensions in a single place (more on this below). However, a Pensions Passport scheme could involve active nudging, for example by presenting people with a reminder to contact their workplace pension provider at the point they register as a sole trader with HMRC or as a company with Companies House. The government could also allow pension providers to automatically follow up with savers who have recently left a workplace pension and offer a continuation of their scheme.
Recommendation #3 — The government should explore options for a Pensions Passport system that would enable the self-employed to carry over a pension from previous employment — The government should work with pension providers and industry bodies to scope out options for creating a Pensions Passport scheme that would allow the newly self-employed to carry forward a pension with a previous employer, potentially facilitated by a reminder when they register as a sole trader with HMRC or as a company with Companies House.
2. Saving enough (and efficiently)
Onwards and upwards
It is not enough to encourage the self-employed to begin saving. They must also be supported to raise their contributions to a sufficient level. What that level should be is contested, and will be different for every individual based on their personal circumstances. The concept of ‘target replacement rates’ — explained in the second chapter — reveals that lower earners should stow away a higher proportion of their income to sustain the living standards they are accustomed to. The Resolution Foundation estimates the self-employed have a median earnings replacement rate of just 53 percent, revealing an alarming degree of under saving. But even were the self-employed to be auto enrolled and contribute the planned minimum of eight percent of their earnings to a pension, many would still fall short of their target rate. The Pensions and Lifetime Savings Association argues that minimum auto enrolment rates need to rise to at least 12 percent, while others like the Pension Institute say 15 percent.
So how can the self-employed be supported to reach these ambitious targets? The pensions company Royal London had previously suggested using the apparatus of the tax system, raising the rate of Class 4 NICs for the self-employed from nine percent to 12 percent, plus another five percent to meet the eight percent minimum for auto enrolment. The extra amount would then be deposited in a pension of their choice. The attraction of this solution is that it offers ‘something for something’, in that the uplift in taxation is ultimately all for the benefit of the saver. But the proposal is also patently unfair. Why, employees would ask, should a portion of the taxes paid by the self-employed go into a personal pension when theirs do not?
This is not to say the tax system cannot be used to spur saving. Indeed, the next chapter presents a plan to reform the tax relief system in this vein. However, more immediate solutions should focus on people’s own capacity for saving. One idea is ‘auto escalation’, which could run in tandem with an extension of auto enrolment to the self-employed. Auto escalation enables savers to allocate a percentage of future salary increases to their pension, so that for example a 50 percent commitment on a five percent wage rise would result in a 2.5 percent rise in pension contributions. The scheme, known as Save More Tomorrow in the US, circumvents the loss aversion bias described in the last chapter.[3] Among workers who took part in the first trial, average saving rates rose from 3.5 percent to 13.6 percent after the fourth pay rise.[4]
Of course, the self-employed do not experience a ‘salary increase’ like employees do. We have already seen how their income is characterised by volatility, so a spike in earnings could well be short lived. This means a direct replication of Save More Tomorrow would not work for the self-employed. However, a variant of this model could be for them to designate a percentage of their revenue (or profit) to a personal pension and commit to increasing this figure incrementally over time. This could again be facilitated by accountancy software providers.
Recommendation #4 — The government should pilot an auto escalation scheme to boost saving rates among the self-employed — Inspired by the promising results of the Save More Tomorrow scheme in the US, the government should work with pension providers and accountancy software providers to pilot a form of auto escalation. This would allow savers to commit to gradually increasing the percentage of their earnings that go into a pension over time.
Scaling up the new Pensions Dashboard
The beauty of auto escalation is that it makes use of inertia. However, there is only so much that nudging can achieve. At some point the self-employed will need to actively engage with their finances. Fortunately, a new data platform in the form of a Pensions Dashboard is due to be launched later in 2018. Once fully established, it will bring together in a single place all of a saver’s pension accounts, allowing them to keep track of their retirement savings and understand how close they are to realising their goals. With millions of pounds worth of pension funds going unclaimed every year, this information portal is sorely needed. However, the government must keep a close eye on its development, which is being driven by the financial industry, and be willing to step in if progress proves sluggish. The Work and Pensions Select Committee recently called for the government to mandate that all pension providers release their data for the dashboard.
It is already possible to see where improvements could be made. As it stands, the Dashboard plans to provide information on the size of people’s pension pots. But could it not also predict what these savings will generate in terms of retirement income? Users should also be able to experiment with different scenarios to understand how alternative saving strategies could change their final pension pot. In the longer term, the government should push for the Pensions Dashboard to become a more comprehensive Money Dashboard — one containing information on every aspect of a saver’s financial wellbeing. This includes data on cash accounts, saving accounts, ISAs, shares and stocks, state pension entitlement and possibly even debt obligations. CPS research fellow Michael Johnson envisages a situation where Dashboard users can ‘drag and drop’ money seamlessly from one account to another, for example offsetting high cost consumer loans against positive cash balances.
Recommendation #5 — The government should create a roadmap for turning the Pensions Dashboard into a comprehensive Money Dashboard — The government should encourage the financial industry to raise its ambitions for the Pensions Dashboard and in time transform it into a wider Money Dashboard, giving savers a rich account of their financial wellbeing and helping them make better saving decisions.
A Money Dashboard of this kind would be a sizeable fintech project, making use of the latest developments in UX and the new ‘open banking’ APIs, which facilitate the sharing of financial information. But modest applications of fintech also exist that can help people better understand their financial position. Smart Pension, a workplace pension platform open to the self-employed, recently launched an app and an Alexa skill, allowing account holders to instantly find out how much they’ve saved so far. Coconut, meanwhile, is a new current account designed specifically for the self-employed, which helpfully estimates tax liabilities and automatically categorises transactions to flag potential expenses. The challenge these apps face is getting people to use them, particularly the less tech savvy. The EY FinTech adoption index highlights that younger, higher income consumers in developed urban areas are the biggest users of these applications.
You say guidance, I say advice
So far, we have discussed how to present the self-employed with accurate and timely information to boost saving rates. But how are they to make sense of this knowledge? For the millions who are unfamiliar with the relative advantages of different saving products and how much money they should put away, advice and guidance can be invaluable. It is concerning, then, that a 2015 YouGov and Citizens Advice poll found a quarter (27 percent) of the self-employed said they had never received information about pensions from anyone, with a further five percent saying they do not recall. The absence of a HR department that can steer them in the right direction is partly to blame. Among employees, 46 percent said they had received pension information from their employer. The problem is starkest for the lifetime self-employed who have zero contact with HR systems.
The good news is that the government has pledged to launch a new Single Financial Guidance Body (SFGB), which should be up and running after autumn 2018. Its purpose is to provide ‘debt advice, money guidance and pension information and guidance’, and in doing so will merge the work of the Money Advice Service, Pension Wise and The Pensions Advisory Service under a single banner. But while this consolidation is sensible, it remains to be seen whether the new Body will have the wherewithal or mandate to offer meaningful support on pension decisions. Critics say it should commit to offering not just guidance on pensions but advice, meaning in practice that clients receive an active steer based on their personal circumstances. The financial journalist and broadcaster Paul Lewis goes as far as to say that “the plan is part of giving the financial services industry a monopoly over the word ‘advice’.”
The government should heed these warnings and commit the Single Financial Guidance Body (SFGB) to offer clear cut advice on pensions. It should also embrace the recommendation from John Cridland’s review of the State Pension age to fund a programme of ‘mid-life MOTs’, the financial aspects of which could be run by the SFGB. In doing so, the government and the SFGB should draw upon the ever-growing corpus of research on behavioural insights to understand how best to convey their advice. This could mean organising pension appointments by default for the most vulnerable groups (as recently suggested by the Work and Pensions Select Committee), crafting bespoke messages for savers based on their beliefs and preferences, and — if possible — finding ways of reaching out to people at key ‘life moments’ when they are more receptive, such as when they enter a new job or get married.
Recommendation #6 — The new Single Financial Guidance Body should be tasked with offering both guidance and advice on pensions — In the absence of impartial long-term savings support for all workers, particularly the self-employed, the government should expand the remit of the SFGB to offer advice on pensions, so that clients have an active steer on how to save.
3. Accessing savings before retirement
Liquid assets for a liquid labour market
Our third set of recommendations relate to the accessibility of savings. Of all the attributes that define self-employment, none stand out more than its inherent insecurity. Taxi drivers can never be sure how many fares they will have from one day to the next, just as plumbers and electricians are blind to how many call outs they will receive in a week. Income is thus characterised by feast and famine. To make matters worse, the self-employed have no access to Statutory Sick Pay should they fall ill on the job, meaning any time spent in recovery is a period of zero earnings. For these reasons, the self-employed are naturally reluctant to lock away their savings in an impenetrable pension, which is only accessible at the age of 55.
Well aware of this problem, several business groups have called for greater liquidity so that the self-employed can dip into funds as they need to, and therefore feel more comfortable saving for the long-term. Some say the UK pension system should copy elements of the 401(k) model in the US, which permits savers to take out loans against their pension plans subject to certain ‘triggers’ being met, such as a major medical expense. While this idea has merit, the push for flexible saving products could easily backfire. Proponents of the US 401(k) system overlook the significant leakage that has occurred from pensions funds. Between 2004 and 2010, for every dollar contributed to retirement accounts among individuals under age 55, between 29 and 40 cents were withdrawn as taxable distributions.
The question is whether a method exists to give the self-employed greater access to their savings without allowing excessive drawdowns. According to the Aspen Institute in the US, the answer is to create a ‘sidecar’ pension model. This would involve wrapping two savings products within one: a short-term rainy day account and a standard pension account. Money going into the scheme would be automatically split between the two accounts, until a threshold has been reached on the rainy day fund (say, £1,000). At this point all the money would be channelled into the pension. A similar scheme called Accessible Pension Savings (APS) has been suggested by the UK debt charity StepChange. This would appear to operate in the same way, except that StepChange recommend their rainy day fund only be accessible under strict criteria, such as emergency home repairs.
The attractiveness of both these proposals is that they offer a degree of upfront liquidity, while using the power of inertia to boost long-term savings which are rightly frozen. Helpfully, the Pensions Policy Institute (PPI) recently analysed the financial implications for different types of savers, looking in particular at what might happen were people to access a rainy day fund multiple times. Assuming this fund’s threshold is set at £1,000, the PPI calculates that a woman earning at the 10thh percentile (ie a very low earner) would be affected as follows:
· If she never uses the rainy day fund, her final pension pot would be two percent smaller.
· If she uses the rainy day fund once in its entirety, her final pension pot would be seven percent smaller.
· If she uses and replaces the rainy day fund four times, her final pension pot would be 20 percent smaller.
In short, the more the rainy day fund is used, the more depleted a person’s final pension pot will be. Yet were the rainy day fund not in place, the chances are that a large number of savers faced with an emergency would cease making pension contributions altogether — an altogether worse outcome. While people’s intention may be to take a short-term hiatus, many would forget to renew their pension or knowingly shun this savings route for fear of facing a repeat emergency. A rainy day fund could also help people avoid using unscrupulous lenders who charge exorbitant interest rates. The PPI estimates that £1,000 worth of accessible cash savings could reduce the likelihood of someone falling into problem debt by 44 percent.
The sidecar and API designs are not perfect. For example, it remains to be seen how tax relief on contributions would be managed. Should relief be applied to the money that flows into the rainy day fund as well as the main pension fund? If so, would drawdowns from the rainy day fund then be subject to the same tax treatment as a pension (ie tax paid at the marginal income tax rate on withdrawals)? For the StepChange scheme, there is also the question of how to determine when people meet the access criteria. Nevertheless, the idea of wrapping together a short term savings account with a pension product shows significant promise, hence why NEST has committed to a trial of the sidecar scheme this year. Other pension providers should pay close attention and decide whether they can follow suit.
Recommendation #7 — Pension providers should consider launching ‘sidecar’ products that combine a short-term savings account with a long-term pensions account — Pension providers should explore the possibility of creating a special product that combines a rainy day fund and a pension account under one umbrella, thereby giving the self-employed the liquidity they desire without undermining a long-term savings culture.
Making the most of the LISA
At the outset of this chapter we called on the government to clarify its strategy for the Lifetime ISA. Without understanding the logic behind it, prospective savers will continue to be confused by two financial products that ostensibly share the same aim. In the meantime, we can form our own opinion as to who the LISA could best serve, assuming its structure remains broadly intact. Chief among these are low earners with volatile incomes, for whom the LISA would provide a degree of liquidity while meeting their modest target replacement rates. Were someone to save £1,000 a year in a LISA account from the age of 18 to 50, they would receive £8,000 in bonuses from the government, on top of a personal contribution of £32,000. Taking into account the benefits of compound interest, this sum combined with the state pension could offer a modest retirement income.
A problem, however, is that the LISA is closed off to a large number of people owing to age restrictions. An account can only be opened by those under the age of 40, and will only pay bonuses up to the age of 50, although people can continue paying into their pots until they reach the age of 60. It is unclear why these age barriers remain in place, other than to keep a lid on the overall cost to the Exchequer. But because take-up of the LISA has been lower than expected, the Office for Budget Responsibility believes the scheme is running under budget. We recommend the government consider raising the age threshold at which people can open a LISA from 40 to 50, and possibly increase this further subject to affordability. Such a move would be particularly beneficial to the self-employed, who are typically older than their counterparts in employment.
Recommendation #8 — The government should extend eligibility of the Lifetime ISA to older savers, beginning by moving the age threshold from 40 to 50 — As well as clarifying the purpose of the LISA, the government should raise the age threshold under which an account can be opened from 40 to 50, offering a compelling long-term savings option for the many self-employed workers on low and volatile incomes.
Coping with ill health
The last two recommendations are aimed at giving the self-employed easier access to their savings, such that they feel able to put money away without fear of being left stranded during an emergency. But what if we could also limit the chance of those emergencies occurring in the first place?
High up on the priority list should be finding a replacement for Statutory Sick Pay (SSP). SSP entitles employees to £89.35 a week for up to 28 weeks, however employers usually pay more than the minimum required. In contrast, the self-employed who fall ill have to rely on the Employment and Support Allowance (ESA), worth £73.10 a week for the over 25s. This is not an insignificant sum, however the problem arises after 13 weeks when payments can become conditional on the receiver applying for work and attending regular interviews, depending on how they fare on the Work Capability Assessment. The Association of British Insurers estimate 80,000 self-employed workers move onto ESA every year.
Fortunately, there is a market-led alternative in the form of income protection insurance, which pays out a percentage of claimants’ wages should they become ill or injured. There is often a modest waiting period before payments can begin, yet cover can in theory last until people retire or become fit and ready to work. Given how much the self-employed have to lose from ill health, it is surprising how few take out income protection insurance. Polling by the FSB found that just nine percent of their members had taken out a policy. One reason is due to the cost and how this varies by occupation. Another is myths about the difficulty of making a claim. ABI research in 2012 found that consumers estimate somewhere between 38 and 50 percent of IP claims are paid. But the reality (based on 2013 data) is 91 percent.
There is only so much the insurance industry and the government can do to clear up falsehoods. Yet measures can be taken to limit the cost of premiums and make IP insurance more affordable. The challenge is to drum up enough commitment so as to generate economies of scale, which in turn makes administrative costs more manageable. A straightforward solution would be to present an insurance policy option to the self-employed at the same time they complete their self-assessment tax return. The self-employed who sign up could either be directed to one of a number of pre-approved private insurance providers, or enrolled onto a government-backed insurance scheme in the same mould as NEST. Inspiration can be taken from Australia’s Group Salary Continuance (GSC) system, which offers IP insurance as a non-compulsory option attached to pensions.
Recommendation #9 — The government should present the self-employed with an IP insurance policy option when they complete their self-assessment tax return — The government should work with the insurance industry to nudge the self-employed to take out income protection insurance, potentially at the same time they are asked to join a pension scheme. This would generate the economies of scale needed to bring down the cost of unaffordable premiums.
4. Accessing savings after retirement
Shifting from accumulation to decumulation
There is little point in people building savings over their careers if that money is hastily spent in retirement. As one expert we interviewed told us, “Until people can be assured of having an income from the time they retire until the time they die, then we don’t have a solution.” Decumulation — as the drawing down of long-term savings is known — has taken on greater significance since the last government introduced pension freedoms in 2015. These meant savers no longer had to take out an annuity but could instead access all their money in one go. Fears this would lead many to irresponsibly splurge their cash on Lamborghinis and other luxury goods appear overstated. But the broader concern that retirees will have difficulty making their money last until they die are justified, particularly when unexpected care costs are taken into account. A new and concerning trend is for people to divest a large sum from their pension and deposit it in low interest current accounts.
How might decumulation be improved? The new Single Financial Guidance Body will be tasked with offering impartial information on drawdown strategies, as PensionWise does today. But given the amount of money at stake and the severe consequences of financial mismanagement, the government should intervene more decisively. A sensible idea tabled by Michael Johnson of the CPS is ‘auto protection’. Building on the same behavioural principles behind auto enrolment, this would default every new retiree onto a scheme that draws down five percent of their pension pot on an annual basis. An alternative would be to default savers onto an annuity, however this has the disadvantage of being impossible to escape at a later date, comes with added regulatory costs, and broadly seems out of tune with people’s desire to hold onto their cash. To streamline auto protection, the government could allow NEST to engage in decumulation schemes, which it is currently barred from.
Recommendation #10 — The government should introduce auto protection rules that default savers onto a drawdown scheme during retirement — To help people spend their savings carefully in retirement, the government should default people onto an automatic drawdown scheme at the age of 65, which withdraws five percent from their pension pot on an annual basis.
Going the distance with CDCs
While auto protection would prevent people from mismanaging their funds, it does not help retirees manage the risk of running out of money in the long-term. Many people will live for 10 years after retirement and have more than enough in their pension to tide them over. But a significant minority will live well into their 90s and have sizeable care costs to shoulder — bills which may not have been expected nor planned for earlier in life. Annuities once dealt with this problem by allowing people approaching retirement to exchange a chunk of their pension pot in return for a guaranteed income until their death. However, the current annuities market is challenging, with wide variations in costs. A 2015 Which? survey identified more than £10,000 in fee differences between products at the 10-year mark. In addition, solvency requirements oblige annuity insurers to invest in safe but low yielding investments, meaning less long-term bang for people’s short-term buck.
It may be that the annuity market corrects itself over time. But with pension freedoms eroding the economies of scale that providers once enjoyed (ie through compulsory annuitisation), this seems unlikely. Fortunately, there are other risk management solutions available, chief among them Collective Defined Contribution (CDC) schemes. Commonplace in Holland and Canada, CDCs operate by allowing a large collective of people to save together and pool money into a joint fund which they all draw upon during retirement. Unlike Defined Contribution plans, savers don’t receive an individual pension pot at retirement but rather a regular income drawn from the pot, which is set as an ‘ambition’ but may change owing to economic circumstances. By pooling risk in this way, all participants are protected regardless of whether they live to 65 or 100. CDCs are typically targeted at employees, but could may well work for the self-employed.
This pension innovation is not without its critics. Some say it is just as rigid as annuities, paying out the same amount to pensioners every year regardless of whether they need less or more (care costs are likely to get higher as people age). Others argue there is no meaningful desire for CDCs in the UK, and what demand there is has been artificially inflated by its proponents. These concerns should be heeded, but they are not enough to dismiss the CDC outright. Only recently, Royal Mail proposed replacing its Defined Benefit scheme with a CDC, while the Work and Pensions Select Committee (WPSC) has launched an inquiry to consider its potential. The government must take such interest seriously and begin drafting the regulatory architecture that CDCs need to get up and running. In doing so, it should pay particular attention to the scope for the self-employed to pool their savings and their risks during retirement.
Recommendation #11 — The government should draft the regulation required for Collective Defined Contribution schemes to take off, and factor the self-employed within these plans — The government, informed by the findings of the Work and Pensions Select Committee inquiry, should finish the regulatory framework for CDCs, and in doing so consider what safeguards need to be in place for the self-employed to create their own CDC models.
An Office for Financial Security among the Self-Employed
The breadth of recommendations detailed in this chapter shows just how much scope there still is to improve the economic fortunes of the self-employed. Equally, we have shown a number of popular proposals to be unjust or unworkable upon closer inspection. This tells us that the debate on how to bolster the retirement security of the self-employed remains nebulous. Various gaps exist in our knowledge base, including our understanding of which subgroups deserve the greatest attention (the lifetime or occasional self-employed?), which interventions have a place in our toolkit of measures (should the LISA continue to exist?), the strength of evidence behind interventions (how will we know if the sidecar model is successful?), and the extent to which interventions meet the criteria of being technically, financially and politically feasible.
We therefore recommend the government establishes a new independent Office for Financial Security among the Self-employed. This would be tasked with:
• Periodically reviewing the financial security of the self-employed
and sounding early warnings of impending challenges (eg using
open banking and HMRC data).
• Identifying and evaluating innovations in financial products,
advice and guidance mechanisms, as well as techniques derived
from behavioural science (eg an evaluation of NEST’s pilot of a
sidecar pension model).
• Funding and overseeing experimental interventions that could
increase the financial security of the self-employed (eg funding a
prototype of auto-escalation).
• Recommending reforms to tax, welfare and regulation based on
the outcomes of these activities.
Such a body could be established in the mould of the Office for Budget Responsibility, and have an obligation to report to both Parliament and the government. While some may question whether the self-employed need their own dedicated investigatory office, without a public body to provide strategic oversight it is likely that research and practice in this space will continue to be piecemeal and fragmented, with little cumulative learning. To give the Office more legitimacy, we recommend it be underpinned by a citizens’ panel that would debate the merits of different proposals. This panel would include both the different types of self-employed worker highlighted in this report as well as employees. The latter group will ensure that any measures to assist the self-employed are fair in relation to the protections and assistance employees receive. Expert stakeholders including unions, pension companies and accountancy trade bodies should also be invited to participate.
Recommendation #12 — The government should establish an Office for Financial Security among the Self-Employed — The government should create a new independent body to bring coherence to the wide array of research and practice aimed at boosting the financial security of the self-employed. This would be tasked with undertaking periodic reviews, commissioning evaluations, funding experiments and making independent recommendations.
- Read more from the RSA on retirement security for the self-employed: Why the pension gap matters?
- Download the RSA Venturing to Retire report (.pdf)
- Follow the RSA on Twitter @theRSAorg
