Defined Contribution Investment and the cost of living 

We hear anecdotally about defined contribution scheme members opting out to meet their immediate financial needs during the cost of living crisis. And this trend may intensify if inflation stays high and as millions of homeowners are affected by big increases in mortgage payments.

Opting out may be a sensible short-term move if someone is in financial difficulty but it is also a costly decision. The numbers are stark and they have implications for the duty of care that employers and schemes have for members.

The more members contribute, the less they need to rely on investment return. For example, an average earner (see assumptions below), auto-enrolee with a total contribution rate of 8% of their salary would need investment returns of c. 4.6% above inflation, net of fees, every year from age 25 to age 68, in order to have a moderate standard of retirement. That’s a reasonably high rate of return to expect, especially in today’s markets.

This return figure drops to inflation plus 2.1% (still tough, but more manageable) for a contribution rate of 15% - or inflation plus 4.8% for a comfortable lifestyle.

Now imagine a world, not completely unheard of, where salaries lag inflation by 4% for three years. More investment return or contributions (or both) are needed to allow for that gap. If those three years of salaries lagging inflation are between the ages of 30 and 33 say, then you need an additional 1% of contributions your whole working life, just to compensate for those three years.

Now let’s look at what happens to someone who opts out of their defined contribution scheme for the full three years when inflation is high.

The result is around a 18% reduction in projected pension pot, which translates into a 10% cut in net annual pension income (i.e. allowing for tax and the state pension) due to the missed contributions, the inflation and the benefit of compounding lost.

A 10% reduction is equivalent to only accruing pension for 4.5 days a week instead of 5. Taking a three-year break when inflation is high effectively wipes out the contributions of every Monday morning for an employee’s whole career.

Members have every right to opt out in tough times — it’s their money and their decision. But individuals can make bad choices without guidance. That’s why auto-enrolment has been so successful at getting millions of people saving in defined contribution plans.

Your members won’t be aware of the impact of opting out unless you tell them. Once they’ve opted out of their defined contribution scheme they are excluded for three years unless they choose to rejoin.

But what if their finances improve? Perhaps energy bills aren’t as big as they expected, they get a pay rise or the wider economic situation improves. Experience shows us that people won’t opt back in until they are automatically re-enrolled — with significant financial consequences.

Here’s what you can do to help members make the right decisions:

• Tell people in advance what three years of opt-out means — in addition to the “free money” from tax efficiency, every Monday morning of their contributions is wiped out.
• Do this in a variety of ways: seminars, emails, videos — different people respond to different messaging.
• Let them know they can opt back in whenever they want but that if they do nothing they will miss out for three years.
• This isn’t a one-off exercise: keep talking to your people so that they understand the importance of opting back in as early as they can afford to.

As an employer you spend a lot of money to give your people the best chance of retiring with a satisfactory income. At a time of crisis it makes sense for you to help your employees make the right decisions:

• When times are tight you can create goodwill by showing you care about your people’s long-term welfare.
• Doing the right thing now protects you against reputational or possibly legal risk if people find they have less money, than they expected, to retire.
• If people can’t afford to retire you could face HR / succession planning issues if there is no room for the next generation of talented employees to advance.

This is all about communication and it doesn’t have to cost a lot of money. You may have processes in place and require some help with the analysis. Or perhaps this is a way to improve your overall employee engagement. Either way, we can help.

Footnote – assumptions for slide / figures

Source: “Moderate” and “Comfortable” retirement as defined by PLSA Retirement Living Standards, October 2021 release, increased by inflation to end August 2022 (Mercer calculation in September 2022). Figures in this section are Mercer calculations in September 2022. Assume pre-retirement investment return of inflation + 2.5% phasing to inflation + 1% from 10 years to retirement and 25% cash from three years. Assumed drawdown with inflation + 1% investment return after fees and inflationary pension increases post-retirement until a pot of £0 remains at life expectancy age. Includes state pension and tax at 2022/23 levels, and assumes tax-free lump sum taken and reinvested to provide income. Salary taken as the average industrial earnings of £613 per week (source: ONS), assumed to increase with inflation (or inflation minus 4% as described). Starting age 25, retirement at 68.