Could early access to pension funds solve the pension gap?

The UK pension gap is set to cause grave problems for more and more people, as they find their pensions will not provide them with a comfortable lifestyle after retirement.

Government moves to bridge the gulf include the introduction next year of an auto-enrolment pension scheme for all workers, and raising the state pension to a flat rate of about £140 a week after 2015.

But all this might not be enough.

In 2005, the Turner Commission calculated that people on an average annual income will need around two thirds of that income to retire comfortably. For an average wage of £26,000, that is around £17,500.

However, Tom McPhail, head of pensions research at broker Hargreaves Lansdown, calculates that a 35-year-old earning £26,000, with the required 8% going into their auto-enrolment pension (increasing in line with earnings) and receiving the planned £140 a week 'universal state pension' on retirement, will still lose out when they stop working.

They will receive a total pension income of just £11,000 - that's £6,000 short of the government goal in today's terms. To make up the shortfall, they would need to save an extra £220 a month.

The government, therefore, still faces a big problem: how to boost pension contribution levels, especially among the less well-heeled. One idea to attract much attention was to make pensions more flexible, so people don't feel their money is locked away for decades come hell or high water. At present, you have to be at least 55 to access your pension: would it help to be able to access it earlier?

Work done by the Pensions Policy Institute in 2008 suggested that a flexible approach to pension saving could help encourage people to contribute up to 12% more. But in April, following industry consultations, the government decided against that option.

The harsh truth

The government found insufficient evidence that people would increase their contributions if they could access them before retirement. Worse, it might have the opposite effect, making it too easy for them to dip into their pension pots for unexpected expenses rather than major emergencies. And that could mean any increase in contributions would be outweighed by pension raids before retirement - so they'd be even worse off once they stopped earning.

The harsh truth is that if you take out some of your pension savings, you'll either have to replace them at a later point or accept a lower retirement income.

Andy Zanelli, head of technical sales at AXA Wealth, puts that into context.

"Say you allowed people early access to just their 25% tax-free lump sum, which was probably the best suggestion on the table, someone who started saving a fixed sum into a pension at 35, aiming to retire at 65, but took out 25% as a tax-free lump sum after 10 years, would have to increase their contributions by 29% from then on to make up the reduction in retirement income."

That would mean someone saving £200 a month into their pension would have to add an extra £58 a month.

A third drawback is that the tax system for pensions would get a great deal more complicated and bureaucratic if people were drawing money out and then continuing to pay in - and that might deter ordinary savers.

But the government has not ruled out the idea of early access; the debate is on hold, but may continue after auto-enrolment has been introduced in 2012. "The government will look at the number of opt-outs from auto-enrolment, and examine why people are opting out. If there are a lot, it is likely to revisit the question of flexibility and access," says Laith Khalaf, pensions analyst at Hargreaves Lansdown.

Pensions a "locked box"

Ros Altmann, director general of Saga, says that without greater flexibility built into the new auto-enrolment scheme, it's unlikely to be a success. At the Liberal Democrat conference she described pensions as "a locked box", inaccessible even in emergencies.

Her idea is that within the auto-enrolment scheme, employer and employee contributions should be kept separate, and if necessary people should be able to draw on their own contributions, though not those of the employer, nor the tax relief.

Another possibility is to somehow link ISAs and pensions. Fidelity International is backing this idea, arguing that if the two were linked, people would see that they have considerable flexibility and could choose when to turn their money into pension savings.

Mike Morrison, head of pensions development at AXA Wealth, has a vision of a more structured single 'lifetime savings plan' for auto-enrolment, offering easily-accessible ISA units as well as locked-away pensions units.

"You might have been 100% in ISA units when you were young, but your contributions would automatically buy progressively more pensions units," he explains. The important aspect of the plan would be that pension investors would no longer feel they were denied access to their very long-term savings.

There's still much work to do, but the chances are we'll hear more about a flexible pension system in future.

Should we have early access?

Yes

• More flexibility could encourage more of us to save for the long term.
•  Some of the funds could be accessed at any time if they were really needed, rather than being completely inaccessible until the age of 55.
•  If employees are not able to draw on their pension funds at all, there's a greater risk that they will opt out of auto-enrolment when it's introduced next year.

No

• There's little firm evidence that increasing access would increase pensions contributions.
• The risk is that if it's possible to dip into a long-term savings pot, people will do so - and not just for emergencies.
• Pensions are complicated enough already. The system would become even more complex and bureaucratic in terms of tax relief and administration.

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