The missing millions
A little under four years ago, the RSA published its first major study on self-employment. Salvation in a Start-Up, as the report was called, highlighted that record numbers of people were turning their hand to running a business, and that this was broadly speaking a positive trend driven by opportunity rather than necessity. Half a decade later and our position remains the same. While some people are undoubtedly pushed into self-employment against their knowledge or better judgement, study after study has shown the vast majority choose it to gain more freedom, to work around their needs and the needs of loved ones, and to make their mark on the world. Only a fraction live up to the stereotype of the oppressed precariat.
But taking a positive view of self-employment does not mean overlooking its shortcomings. From the absence of sick pay to the dearth of training, and from the raw deal of Universal Credit to the lack of parental leave and pay, the life of a self-employed worker is replete with perils and pitfalls. No challenge is more acute than their lack of preparation for retirement. The self-employed are excluded from auto enrolment and they have no employer to top up their pension contributions. While the proportion of employees making payments into a personal pension leapt from 51 percent in 2010/11 to 62 percent in 2015/16 (largely owing to auto enrolment), participation among the self-employed fell from 23 percent to just 17 percent.
Even when the self-employed do save for the long-term, they tend to save too little. Whereas 52 percent of employees have in excess of £100,000 in pension wealth by the time they approach the state retirement age (between 55–64 years old), the same is true of just 33 percent of those who work for themselves. As many as a quarter (26 percent) of the self-employed in this age group have nothing stowed away in a pension, versus 16 percent of employees. In addition, the self-employed appear to begin saving at a late age, thereby missing out on the benefits of compound interest (what Einstein fondly called the ‘eighth wonder of the world’). More than 80 percent of self-employed people aged 25–34 hold nothing in pension wealth.
Why pensions matter
At this point, it is common to hear the refrain that not everyone needs a pension. The self-employed may have alternative long-term saving strategies, not least investing in property. Indeed, the self-employed seem to have a special affinity for bricks and mortar, with nearly half (46 percent) saying this is the safest way of saving for retirement, versus a quarter of employees. Yet property is not as failsafe as many would believe. The market may falter in the near future, making it difficult if not impossible to sell up. Equity release can be used to access funds without moving home, but is often eye-wateringly expensive. Property is also less tax efficient than pensions, given the imposition of Stamp Duty.
Another reason the self-employed may avoid pensions is because they consider business assets to be their nest egg. In practice, this could be mean giving up equity in one’s company or more simply selling on machines, tools and vehicles. It is not difficult to imagine a taxi driver putting their cab up for sale or a self-employed builder ringing up income from various work tools. However, the sums in consideration are often very modest. While 40 percent of the self-employed hold some business assets, fewer than 20 percent hold upwards of £10,000 and less than 10 percent hold more than £100,000. Altogether, just seven percent of the self-employed say the sale of their business will form the bulk of their retirement income.
A third alternative savings strategy is to rely on a partner’s pension income. Of the self-employed who hold little to nothing in their own pension, one in five live in a household with over £100,000 in pension wealth, with most of these holding upwards of £200,000. Overall, around 10 percent of the self-employed could be seen as intending to fall back on the pension income of their other half. While this is not an insignificant number, partners are clearly unable to offer much of a savings cushion for most people. Even when couples do agree to split a generous pension pot, sadly there is no guarantee of this commitment lasting the course. A 2013 ONS study estimated 42 percent of marriages end in divorce, with more than half of these winding up in the first 10 years.
What’s stopping them?
Pensions are not a panacea. But as far as long term saving vehicles go, they are the best and safest option available. Why, then, is the take-up rate so low among the self-employed and falling further still? One answer is a matter of simple arithmetic. The full-time self-employed take home a third less in pay than their counterparts in salaried employment, making it difficult to find spare income to put into reserve. The self-employed are also known to have volatile incomes, meaning they are wary of locking away money in a pension which they could need at any moment, for example should they fall sick or have a dry spell in the business. Late payments compound this problem.
A second set of barriers relate to knowledge. Unlike employees, the self-employed have no HR department to remind them about pensions or to offer advice and guidance about how much to save and with whom. Polling by Citizens Advice found that a quarter (27 percent) of the self-employed have never received information or advice about pensions from anyone. Yet it is not just a lack of information that is a hindrance, but misinformation too. Qualitative research has revealed troublesome myths harboured by many of the self-employed, such as that pensions always need to be paid at a flat-rate (they do not), and that ISAs are more tax efficient than pensions (they are not). Partly to blame for this confusion are the frequent changes made to pensions policy, from the new pension freedoms to auto enrolment to the introduction of the Lifetime ISA.
Even when the self-employed earn enough and know enough, saving behaviour can be undermined by a third barrier: cognitive biases. Myopia, for example, means people overweight the present relative to the future, while availability bias captures the human tendency to remember salient information that is often negative. A single story about a pension fund crash is more likely to be recalled than multiple positive reports about healthy pension returns. Of course, biases are not unique to the self-employed, but their effects may be amplified in the context of running a business. With so much time spent creating a product or service, winning over new customers and managing accounts, rarely do the self-employed have spare cognitive bandwidth to think about their future selves.
Four pillars, 12 fixes
So what is the solution? No shortage of ink has been spilled on the subject of boosting pension coverage for the self-employed. However, past analysis has suffered from several flaws. One of these is the tendency to search for a singular answer when a multi-pronged approach is needed, given the heterogeneity of the self-employed workforce. Another is that self-employment and employment have often been treated as two separate enclaves when in reality people move freely between them during their careers. Most of all, there has been an overzealous fixation on the question of how to get the self-employed saving, with far less attention paid to whether they are saving enough or can access those savings before and after retirement. This report broadens the debate to cover four pillars of retirement security, and lays out several interventions underneath each:
- Saving something — The self-employed must be encouraged and enabled to enlist onto a suitable long-term savings product. But which one? By ostensibly competing with pensions, the launch of the Lifetime ISA (LISA) may have added another layer of complexity to an already confusing landscape of financial products. As a first step, the government must clarify the purpose of the LISA and explain the gap it is intended to fill. In partnership with the pensions industry, the government should also redouble its efforts to find a model of auto or assisted enrolment for the self-employed, potentially by placing a new duty on accountancy software providers to enlist their clients onto a pension. Furthermore, we recommend introducing a ‘Pensions Passport’, which would allow employees moving into self-employment to continue contributing to a pension with their existing provider.
- Saving enough — The self-employed must be supported to raise their contributions to a sufficient level. This could mean implementing an auto escalation system, whereby the self-employed commit to gradually increasing the percentage of revenue or profits diverted into a pension. Another idea is to present the self-employed with more timely information on the state of their finances, thereby allowing them to make better judgements on what they can afford to save. Over time, the new Pensions Dashboard should be transformed into a more comprehensive Money Dashboard. This would contain information on every aspect of a saver’s finances — from pensions to ISAs to current accounts and even debt obligations. The government should also expand the remit of the new Single Financial Guidance Body to offer not only guidance but impartial advice.
- Accessing savings before retirement — The self-employed need greater access to their savings to see them through bouts of illness and periods of feast and famine. But taken too far, liquidity could lead to excessive pension drawdowns. The pensions industry should consider introducing a ‘sidecar’ pension product that would wrap together two accounts in one: an accessible rainy day fund and a standard pension. Money flowing into this product would be automatically split between the two pots, until a threshold has been reached on the rainy day fund. We also recommend the government take measures to address the lack of sick pay among the self-employed, which indirectly hinders a long-term savings culture. This could mean presenting an income protection (IP) insurance policy to the self-employed as they complete their tax self-assessment.
- Accessing savings after retirement — Finally, the self-employed must be supported to make careful use of their savings after they retire. With the advent of new pension freedoms — namely the removal of a compulsory annuity — individuals risk spending too much of their money too quickly, leaving insufficient funds to pay for potential care needs in later years. While this risk afflicts both the self-employed and employees, the former are likely to have smaller pension pots and must therefore manage them more cautiously. As recommended by the Centre for Policy Studies, and recently endorsed by the Work and Pensions Select Committee, the government should introduce a system of ‘auto protection’, which defaults savers onto a drawdown scheme at the age of 65, withdrawing five percent from their funds every year. In addition, the government should throw its weight behind Collective Defined Contribution schemes, which would provide a guaranteed income in retirement.
To bring coherence to these efforts, we recommend the government establish a new Office for Financial Security among the Self-employed. This would be tasked with undertaking periodic reviews into the financial health of the self-employed, commissioning evaluations (eg of NEST’s sidecar pension trial), funding practical experiments (eg of auto escalation), and making independent recommendations. The Office would be given greater legitimacy were it to be partially steered by a citizens’ panel. This would be made up of both self-employed and employee workers and tasked with shedding light on the trade-offs of different proposals.
Tax relief for the many
Each of these recommendations aims to make it easier for the self-employed to prepare for retirement. Yet this group of workers will continue to face penury in old age unless we grapple with a more fundamental question: where will the money to save come from? Recall that many of the self-employed subsist on low incomes (even if a minority are asset-rich), with half earning below the National Living Wage.
For this reason we finish our report by calling for an ambitious reform of the tax relief system, which would significantly boost government support for low and middle-income savers. As it stands, tax relief is provided at a person’s marginal income tax rate, meaning a Basic Rate tax payer gains 20 percent tax relief while a Higher Rate tax payer enjoys 40 percent tax relief. This system is regressive. If we accept that income tax is progressive, then relief at marginal tax rates must be the opposite. According to new RSA modelling, only 30 percent of government spending on tax relief goes to Basic Rate tax payers, despite them making half of all pension contributions. We estimate that 40 percent of total tax relief expenditure flows to the top 10 percent of earners.
We propose replacing the existing multi-tiered tax relief system with a single flat-rate of tax relief — or a ‘tax bonus’ — worth 30 percent. This means anyone wishing to save £100 in a pension would only need to contribute £70. Our modelling suggests that a single tax bonus set at this rate would leave approximately 75 percent of existing pension savers better off, while up to 25 percent would lose out. Basic rate taxpayers who currently take home 30 percent of all tax relief would accrue 50 percent under a single flat rate, while higher rate taxpayers who for now capture 50 percent of all tax relief would benefit from 40 percent in future (see Table 1). A self-employed worker on an income of £15,600 who contributes five percent of their salary to a pension would see their tax relief jump from £195 a year to £335. A tax bonus of this kind would not only boost pension pots but incentivise higher saving rates.
The journey towards a flat rate tax relief would not be simple. Defined Benefit pensions in particular could jar with such a model, in part because they operate on ‘Net Pay’ arrangements where offering tax relief at anything other than the marginal tax rate is difficult. Yet hurdles such as these are not insurmountable. As for the financial implications, we estimate a 30 percent tax bonus would cost the Treasury broadly the same as the current system. Were it to require extra funding (eg if it led to considerably higher pension contributions), savings could made by making modest changes elsewhere, such as by reducing the Annual Allowance threshold. The government should commission an independent review into tax relief, which would lay out possible options for reform and begin raising public awareness of their consequences. Legitimacy matters more than expediency, and the government must form a mandate prior to making any changes.
To recap, while our findings show that many of the self-employed are heading for hardship in old age, this outcome is far from inevitable. The self-employed are not destined to be destitute. The problem is that our tax, welfare and regulatory systems have failed to keep pace with new ways of working. However, if through concerted effort and political courage, the measures recommended in this report are fully adopted, then self-employment would become less a lifestyle to fear and more a vocation to savour. The future could be one where thousands more people strike out in business to fulfil their passions, solve problems, build life-changing products, and find dignity through independent work. That is surely the makings of a richer society, and a vision we can all get behind.