Replacement rates - the amount of income your savings will allow you to produce in retirement, expressed as a ratio of your working life income - are widely used as a yardstick to measure whether populations will be able to replicate their standard of living in retirement, in order to sufficiently enjoy their “golden years”. However, whilst still a useful metric, replacement rates are increasingly offering a one-dimensional perspective in what has become a multi-dimensional world, says Simon Chinnery, Head of UK Defined Contribution, J.P. Morgan Asset Management.
“An increasing body of evidence suggests future generations may be approaching retirement with higher debt levels. Bankruptcies amongst those aged 65 and over, for example, have increased by 470% in the decade between 2001 and 2011[1]. We could, therefore, potentially see more individuals cashing in their defined contribution (DC) savings to pay off their debts, particularly in light of this year’s pension freedoms. Unfortunately replacement rate calculations do not take into account the debt levels of a population,” comments Chinnery.
In New Zealand and Australia, for example, where liberalised pensions systems have no limits on individuals accessing their DC savings, pension pots are being tapped into to pay down rising levels of mortgage debt.
“Many individuals face the difficult juggling act of trying to save for retirement whilst managing personal debt and we may see those lines blur even further, as more individuals accrue debt with the knowledge that they can use their pensions savings to address them,” continues Chinnery.
Pension pots were previously framed in terms of the regular income they could purchase by way of an annuity but with many savers choosing to stay invested as a result of the pensions freedoms, the concept of ‘replacement rates’ are increasingly becoming less relevant and meaningful to individuals.
“Replacement rates are less equipped to address the emerging set of questions individuals now have as a result of the new freedoms (i.e. what size pot do I need to get on with retirement?). We, as an industry, therefore have to help move the conversation forward and think how we can evolve traditional metrics in a world where there’s no longer a single-track road to securing retirement income but many forks in the road that individuals have to choose from,” concludes Chinnery.
Chris Curry, PPI Director, said “While the introduction of the new pension flexibilities brings into question the use of replacement rates at the individual level, they may remain a valuable tool to measure the extent to which the population risks having inadequate retirement income. However, other approaches will increasingly be used to measure adequacy of retirement income in the future, including the use of a threshold for a ‘comfortable retirement’[2] that takes into account factors such as individuals’ satisfaction with their lives, and measures which allow for the flexible use of assets and which take account of debt.”
To read the findings of the original PPI Briefing note ‘Measuring adequacy under the new pension flexibilities’ please click below
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