1 Department for Work and Pensions, UK

Replacement Rates in Pensim2

Stewart Butler

Pensim2 Team

Model Development Unit

Department for Work and Pensions

2 Department for Work and Pensions, UK

Introduction

• Background: UK Pension System

• What are replacement rates?

• Previous UK work

• What Pensim2 offers us

• What matters?

– Income

– Relativity

– Adequacy

• Features specific to Pensim2 analysis

• Summary

3 Department for Work and Pensions, UK

UK Pension System

4 Department for Work and Pensions, UK

Replacement Rates

Replacement rate = Retirement Income

Work Income

Undersaving:

If replacement rate < threshold then undersaving = 1

5 Department for Work and Pensions, UK

Previous UK work

• Pensions Commission 2004/5

Assumed everyone started contributing at age 30 and continued until retirement

• Institute for Fiscal Studies 2005

Survey dataset of individuals aged 50

Limiting assumptions on how people continued in work and contributed to pension schemes

6 Department for Work and Pensions, UK

What Pensim2 offers…

• Has a representative sample of the UK population fusing both administrative and survey data

• Rich set of assumptions and estimations

• Simulation of life courses until 2100

Assumptions

- Policy framework - Pensions parameters - Macroeconomic parameters - Structural trends

n iterations

Base data

Pensions: accrual or in payment depending on age.

- State pensions - Private pensions

Mortality

Education

- Labour market status - Job characteristics - Earnings

Other processes

- Housing - Saving - Tax and benefit

Output data

Family change

- Partnership - Fertility - Marital

7 Department for Work and Pensions, UK

Pensim2 Methodology

Benefit Unit Dataset Individual Dataset

25<=Age< State Pension Age

Benefit Unit DatasetWith Person Identifiers Appended

Pay Information

Retirement Information

2 Person Benefit Unit:∑ (Pension1, Pension)

∑ (Pay1, Pay2)

1 Person Benefit Unit:Pension

Pay

8 Department for Work and Pensions, UK

What Matters? Income

• But what income?– Average lifetime income– Last year of work income– ‘Best of’ last X years– Average of ‘peak’ earning years

Evolution of Mean Replacement Rates

0

0.2

0.4

0.6

0.8

1

1.2

1.4

2006

2008

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2018

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2050

Lifetime Work Income Last Year Positive Income

Best of Last 10 50-SPA

9 Department for Work and Pensions, UK

What Matters? Income

Evolution of the Proportion of Undersavers under different Work Income Definitions

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2006

2008

2010

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2050

Lifetime Income Last Year of Positive Work Income

Best of Last 10 Years 50-SPA

Here we will chart the corresponding ‘undersavers’

Thresholds (of gross income):

80% Poorest

70%

67% Median Income

60%

50% Richest

10 Department for Work and Pensions, UK

What Matters? Income

And not just working age income….

Mean Replacement Rates Under Different Pension Income Specifications

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2006

2008

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1st Year Lifetime Pension

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What Matters? (Pension) IncomeAnd the corresponding number of undersavers….Evolution of Undersavers under different Pension Income Definitions

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2006

2008

2010

2012

2014

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2018

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Lifetime 1st Year

12 Department for Work and Pensions, UK

My old car My son’s car

What Matters? Relativity

Earnings IndexationPrice

Inde

xatio

n

Hmm, I think I’d like a new car for my retirement…

Undersavers

Threshold adjusted for inflation:

2006 1002012 94

Difference -6%

Undersavers

Threshold adjusted for earnings: 2006 196

2012 200Difference 2%

Results are presented relative to the number of undersavers under the price threshold in 2006

13 Department for Work and Pensions, UK

The Effects of Spreads in Economic Assumptions

0

0.2

0.4

0.6

0.8

1

1.2

1.4

2006

2008

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2050

Standard Economic Assumptions Low RPI and Earnings High RPI and Earnings

What Matters? Relativity• The Effect of Spreads in Economic Assumptions

Equates to a difference in undersavers of around 16% in 2040

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What Matters? Adequacy• How do we define what is an adequate retirement income?Different Thresholds for Adequacy

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

2006

2008

2010

2012

2014

2016

2018

2020

2022

2024

2026

2028

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2032

2034

2036

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2040

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2050

60% 2006 Median Income

Pen Comm

15 Department for Work and Pensions, UK

Features specific to Pensim2 analysis

• Units of Observation

– We are looking at a point in time estimation but using modelled outputs from future periods

• Non-Pensions Wealth

– At present we do not include wealth in Pensim2 modelling• Likely to bias results especially further up the income scale

– We are working wealth into our analysis by applying a distribution estimated from a survey dataset

– Planned wealth module in Pensim2 to incorporate accumulation and decumulation of wealth

16 Department for Work and Pensions, UK

Summary

• Pensim2 offers us the ability to comprehensively model replacement rates, using a much richer set of assumptions than was previously available. Important when looking at pensions policy with long time horizons.

• Especially important to define the assumptions and definitions for analysis before you start to avoid trying to pick a number that you like best.

• Can be difficult to unpick the effect of individual assumptions due to number of life events estimated and the interaction between these.

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Contact

Stewart Butler

Pensim2 Team

Model Development Unit, Department for Work and Pensions, UK

Stewart.butler1@dwp.gsi.gov.uk

+44 207340 4097

18 Department for Work and Pensions, UK

References

• Pensions: Challenges and Choices, The First Report of the Pensions Commission, 2004

• A New Pension Settlement for the Twenty-First Century, The Second Report of the Pensions Commission, 2005

• Prepared for Retirement? The Adequacy and Distribution of Retirement Resources in England, Banks et al., Institute for Fiscal Studies, 2005