Need to know
- Auto-escalation is a design built into a pension scheme that automatically increases contributions on a set date at regular intervals, for example, April each year.
- While it is similar to the Save More Tomorrow concept in the US, auto-escalation has not yet taken off to any great extent in the UK.
- Auto-enrolment can be viewed as a type of auto-escalation, but many people in the industry suggest that the contributions alone will not provide an adequate retirement income.
Auto-enrolment was implemented to seek a solution to the fact that many employees were not saving enough for retirement, and did not have access to a workplace pension. However, since the contribution rates were first set, critics have argued that these alone will not provide an individual with a comfortable retirement income.
Royal London’s Death of retirement policy paper, published in February 2016, found that if an average wage earner starts saving the minimum contribution level when they are 35, they will need to work to the age of 79 for a gold-standard pension (a total pension of two-thirds of their pre-retirement income) with index linking and survivor benefits. The average wage earner will need to work until they are 78 for an index-linked pension, where retirement income is linked to the level of inflation, and to the age of 76 for a level pension, where they receive a fixed retirement income.
Auto-escalation has been suggested as a means of overcoming the issue of low contribution rates. Working in a similar vein to the concept of Save More Tomorrow in the US, which sees employees increase their contribution rate when they receive a pay rise, auto-escalation requires employees and employers to increase their contributions on a fixed scale at a pre-determined interval. Rona Train, partner at Hymans Robertson, says: “Most pension schemes tend to have a flat rate of pension contribution; most structures [keep] that amount on a consistent basis throughout someone’s life, for example a 5% and 5% match each year.”
Auto-escalation sees that amount increase each year, usually at the same rate, for example 1%, so that contribution rates gradually increase, with a cap set at some future time point.
An ideal date in the year to increase contribution levels is at the time of the annual salary review and pay rise. “As people’s salaries go up and they get promotions, their level of contribution goes up at the same time,” says Train. “The argument is that [when an employee gets a pay rise], if that comes off automatically, they won’t really notice what they don’t have.”
Of course, this is reliant on an environment of steady pay growth, and requires an employee to sign up to the scheme. Alan Morahan, managing director at Punter Southall Aspire, says: “There does have to be a process sitting behind that; there needs to be rules built into the payroll system so that it is automatically picked up. It’s appropriate to remind employees that the increase is going to happen, and that they have the opportunity to opt out of future increases, if for whatever reason they feel it is not appropriate to do so.”
Auto-escalation has not taken off to any great extent in the UK as yet, perhaps while employers ensure that their pension schemes are fit for auto-enrolment and the pension freedoms requirements. Andy Parker, principal at Mercer, says: “In the UK, there are very few organisations that do [offer auto-escalation] and that’s typically because the focus has been more on designing the pension plan, getting it up and running, meeting all the new regulations. Maybe the next step will be a real focus on member benefits; how much money members are actually going to get from their defined contribution plan.”
Taking the lead from the way the scheme operates in the US is not a bad thing, says Morahan. “There’s little experience in the UK, but the wider experience in the [US] is that good numbers of people stick with it. Even if they don’t go through the full process, maybe five or seven years, they will normally allow some increase to happen and it’s probably more than would have happened had that form of auto-escalation not been in place,” he says.
Auto-enrolment can be viewed as a kind of auto-escalation plan because of its gradual increase to the 8% total contribution rate in 2019. Auto-enrolment could help raise awareness among employees of the importance of effective retirement planning and the impact that their contribution will have. “The point to make on top of [auto-enrolment] is that we all know that the 8% going in for the vast majority of people is not going to be enough,” says Train.
“The question is what happens to auto-enrolment rates over time? Is there a strong argument that once we get to the auto-enrolment rate in [2018/2019], should the system then be looking to auto-escalate people on a continual basis after that?”