Replacement Rates in Pensim2

1. Replacement Rates in Pensim2 Stewart Butler Pensim2 Team Model Development Unit Department for Work and Pensions

2. 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. UK Pension System

4. Replacement Rates Replacement rate = Retirement Income Work Income Undersaving: If replacement rate < threshold then undersaving = 1

5. 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. 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

7. 2 Person Benefit Unit: ∑ (Pension1, Pension) ∑ (Pay1, Pay2) 1 Person Benefit Unit: Pension Pay Pensim2 Methodology Benefit Unit Dataset Individual Dataset 25<=Age< State Pension Age Retirement Information Benefit Unit Dataset With Person Identifiers Appended Pay Information

8. What Matters? Income • But what income? • Average lifetime income • Last year of work income • ‘Best of’ last X years • Average of ‘peak’ earning years

9. What Matters? Income Here we will chart the corresponding ‘undersavers’ Thresholds (of gross income): 80% Poorest 70% 67% Median Income 60% 50% Richest

10. What Matters? Income And not just working age income….

11. What Matters? (Pension) Income And the corresponding number of undersavers….

12. Undersavers Threshold adjusted for inflation: Undersavers Threshold adjusted for earnings: Hmm, I think I’d like a new car for my retirement… My son’s car My old car What Matters? Relativity Results are presented relative to the number of undersavers under the price threshold in 2006 Price Indexation Earnings Indexation

13. Equates to a difference in undersavers of around 16% in 2040 What Matters? Relativity • The Effect of Spreads in Economic Assumptions

14. What Matters? Adequacy • How do we define what is an adequate retirement income?

15. 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. 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.

17. Contact Stewart Butler Pensim2 Team Model Development Unit, Department for Work and Pensions, UK Stewart.butler1@dwp.gsi.gov.uk +44 207340 4097

18. 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