Increasing automatic enrolment (AE) contributions to 12 per cent of earnings from the first pound could reduce low earners’ take-home pay by 4 per cent if higher employer costs ultimately feed through into lower wages, the Institute for Fiscal Studies (IFS) has warned.

The IFS report, Automatic enrolment: trends in employer pension contributions and the impact of potential reforms, found that higher minimum contributions could materially improve retirement adequacy, particularly for younger workers, but would create significant trade-offs for employees, employers and the public finances.

Under its most extensive reform scenario, the minimum total contribution would increase from 8 per cent to 12 per cent, including a 6 per cent minimum employer contribution, and would apply from the first pound of earnings up to £65,000.

The AE earnings trigger would also fall from £10,000 to £4,000, while the eligible age would be reduced from 22 to 18.

The IFS estimated that this approach would generate an additional £17bn of annual pension contributions - £9.8bn from employers and £7.2bn from employees.

However, among the lowest earners, the direct impact of higher employee contributions and the assumed full pass-through of increased employer contributions into lower wages could reduce take-home pay by 4 per cent.

The equivalent reduction was estimated at 3 per cent for middle earners and less than 1 per cent for the highest earners.

The IFS stressed that the modelling did not account for behavioural changes or employer responses, including higher opt-out rates, changes in hiring or reductions in contributions among employees already saving above the minimum.

Nonetheless, it said economic theory and existing evidence suggested most higher employer pension costs were likely to feed through into lower wages or slower wage growth over time.

“The clearest trade-off is simply that more saving has to be paid for somehow - by individuals, their employers or the state,” the report stated.

“In general, increasing pension contributions through automatic enrolment will lead to lower take-home pay today, regardless of whether the extra contributions are made by employees or their employers.”

Despite the impact on current incomes, the IFS found that the most substantial reforms could significantly increase the number of defined contribution (DC) savers on course to maintain their living standards in retirement.

Under current saving patterns, 66 per cent of private sector DC savers aged between 25 and 59 were projected to achieve their target replacement rate, which measures retirement income against earnings during working life.

Increasing total contributions to 12 per cent while retaining the lower qualifying earnings limit of £6,240 would raise this proportion by 8 percentage points to 74 per cent.

Applying the 12 per cent contribution from the first pound would increase it by 12 percentage points to 78 per cent.

The effect would be greater for younger employees because they would spend more of their careers saving under the reformed system.

Indeed, among DC savers aged between 25 and 34, applying a 12 per cent rate above the £6,240 lower earnings limit would increase the proportion achieving their target replacement rate by 14 percentage points.

Removing the lower earnings limit as well would produce a 19 percentage point increase.

However, the impact was more limited when adequacy was measured against Pensions UK’s minimum Retirement Living Standard (RLS).

The IFS projected that 91 per cent of DC savers were already on course to reach this threshold, largely because the full new state pension brought many people close to the minimum income level.

The four reform scenarios modelled by the IFS increased the proportion meeting the minimum standard by between 2 and 4 percentage points.

The report also highlighted the affordability challenge facing lower-income households, finding that 23 per cent of people in working households currently had incomes, after housing costs, below the minimum RLS.

It questioned whether these households should be required to reduce their living standards further during working life to build additional retirement savings that would remain inaccessible until later life.

The IFS suggested that, should the Pensions Commission recommend higher saving among low earners, policymakers could consider integrating a more accessible savings account into the AE system.

This could allow individuals to build emergency savings that were accessible during financial hardship before further money was directed into a pension.

However, it acknowledged that such an approach would increase complexity, costs and administrative requirements for employers and pension providers.

Meanwhile, the report also found that the design of the qualifying earnings band could have as significant an impact as the headline contribution rate.

Under the current system, the minimum 8 per cent contribution applies only to earnings between £6,240 and £50,270.

The IFS noted that removing the lower limit would have the greatest proportional impact on low earners, but would also materially increase saving among those on middle and higher incomes.

Indeed, its previous Pensions Review proposal, which included a 3 per cent non-contingent employer contribution and a 10 per cent total contribution above £9,000, would generate an estimated £7.1bn in additional annual saving.

A 12 per cent rate retaining the £6,240 lower limit would produce £9bn.

Ultimately, the report found that employers in sectors with large numbers of low-paid and minimum-wage workers would face the greatest pressures from higher mandatory contributions.

Under the 12 per cent first-pound scenario, employer costs in accommodation and food services would increase by an estimated 1.75 per cent of total remuneration, compared with 0.21 per cent in finance and insurance.

Employers would be unable to offset the additional costs by reducing hourly pay for workers already earning the minimum wage, potentially leading to lower recruitment, higher prices, lower profits or changes to working conditions, the IFS said.

Small businesses would also be disproportionately affected.

Almost half (47 per cent) of DC savers employed by firms with fewer than 50 workers received the statutory minimum employer contribution in 2024, compared with 17 per cent at employers with at least 10,000 workers.

Therefore, the IFS warned the Pensions Commission would need to balance improved future retirement incomes against lower current living standards and increased costs for employers.

It also called for any reforms to be announced well in advance and underpinned by long-term policy stability and cross-party agreement.

“Getting this right, and striking the right balance on the trade-offs, will mean that AE can continue to evolve in a way that improves retirement outcomes for those currently on track to fall short,” the report concluded.

---