UK pension schemes could offer members an enhanced payout phase experience through greater forward planning and tapping into the range of options available, finds Rachel Fixsen
DC pensions in the UK can hardly be accused of standing still - if you’re talking about the investment phase, that is. New legislation, new products and changes of emphasis to existing ones have kept the marketplace a lively one.
But the same cannot be said for what happens to a pension later on.
“This is an area that’s ripe for innovation and, by and large, it has been ignored up to now,” says Richard Butcher, managing director at independent trustee company, Pitmans Trustees.
“The pensions minister, Steve Webb, seems to be behind innovation, so we’ve got an environment that is benign for introducing new ideas,” Butcher says.
Trustees of DC schemes find that they simply have little choice in the options they can offer people embarking on this final phase of their pension. “At retirement, we buy the annuity. We hope the member can be engaged with so we can help them to make an informed decision,” Butcher says.
Andrew Cheseldine, principal at consultancy Lane Clark & Peacock, also notes the lack of flexibility offered in the payout of trust-based DC schemes in the UK. On retirement, members are allowed to take 25% of the pension pot as a tax-free lump sum and the rest must be used to buy a retirement
“There is a whole range of options for this phase but, in practice, schemes only allow you to take an annuity. The reason for this is that the trustees are responsible for the security of those benefits,” he says.
While trustees might, in theory, have the facility to pay an income directly from the scheme, Cheseldine says some schemes will not give members of the DC scheme that choice because of the risks that involves to the trustees.
Cheseldine highlights the repercussions of the court case Bridge Trustees v Houldsworth, which has made schemes very aware of the liability dangers in mixing DB and DC (see panel ‘Can a defined-contribution scheme legally be seen as definedf benefit?’).
The Pensions Regulator has produced guidance on the decumulation process, mainly, it says, to encourage trustees and employers to think carefully about the retirement options offered by their scheme, and to follow good practice likely to lead to informed decisions being made.
The agency also wants those in charge of DC schemes to recognise and emphasise to members the advantages of getting authorised financial advice.
In practice, the decumulation process of a DC pension is often only considered in the last few months before a scheme member retires. But Towers Watson believes action should begin much earlier than that.
The best way to design the payout phase is to structure a process that permits members to make their own educated decisions and for it to start long before retirement, says senior investment consultant Daniel Morris.
This process should start with a phase of education and awareness, he says, starting perhaps up to 10 years before retirement, followed by fact finding and planning, which could start one-and-a-half to two years before retirement.
Lastly, with between six and nine months to go, the process should close with “income execution” - putting the income into payment, he says.
One lesson the UK could learn from the US on the decumulation phase of DC pensions, according to Morris, is that people tend to dislike annuities. “Around two percent of US retirees buy annuities,” he says.
But most in the industry see the instruments continuing to dominate for the foreseeable future, because they offer security that few other pension income options could match.
At the moment, 80% to 85% of those retiring from a DC pension scheme in the UK choose to buy a level annuity, and only around 1% pick something other than an annuity, Morris says.
This could now change, since UK law changed the requirement to use a pension to buy an annuity by the age of 75. The proportion of people taking other options could rise to 5%, he predicts, but sees the vast majority continuing to rely on annuities because of the predictability they offer.
As things stand, retirees can opt for a level or escalating annuity, which can be joint or single. Guarantees are often available, which pay out what is left of the original sum to an estate on death. Investment annuities can also be an option, which link income paid to the performance of a with-profits fund - usually with a guaranteed minimum income.
People with certain health conditions can buy enhanced annuities, which offer 10-15% more in income.
“Most schemes only allow you to do income drawdown if you transfer out into a personal pension. Transferring out will give you access to a whole range of flexible drawdown and capped drawdown options,” Cheseldine says.
Standard Life sees an increasing use of drawdown for those with more significant DC funds, according to Jamie Jenkins, head of workplace strategy.
“Drawdown can give the added flexibility of varying withdrawals to suit changing financial needs, while keeping the remaining fund invested to take advantage of any further growth,” he says.
“Other options include with-profit annuities and variable annuities, but both remain relatively niche and the flexibility has to be considered alongside any increase in cost,” Jenkins adds.
Despite the perception that drawdown is only for those with huge pension pots, Rona Train, investment consultant at Hymans Robertson, says that income drawdown might be suitable even for people who do not consider themselves highly paid.
“Our analysis suggests that anyone earning over £35,000 and contributing 10% a year for 35 years is likely to have pot big enough to consider drawdown,” she says.
If income drawdown is to be the method a pension scheme member uses in the payout phase, preparation should begin in the investment phase.
Income drawdown has implications both for the appropriate de-risking strategies within any lifestyle or similar strategies, Train says, as well as for the product development needed to take DC trust-based members beyond retirement - whether within the scheme itself or through a seamless transfer to a SIPP (self-invested personal pension) product.
“Few schemes have actually changed the way in which investments are de-risked in the run-up to retirement,” Train says, “but we are increasingly seeing schemes consider the introduction of de-risking phases that leave members with a greater proportion of assets in return-seeking investments at retirement.”
A key step in the decumulation process is for members to be offered the open market option - a legal requirement for both occupational pension schemes and personal pensions. Shopping around for an annuity can produce a far better benefit.
Figures from the Association of British Insurers (ABI) show that more and more people are buying an annuity from a provider other than their pension provider. But around a third of people simply take the annuity offered, potentially losing thousand of pounds over the course of their retirement, it says.
Butcher says that more could be done with annuity design to cater for the pattern of income needs. For example, retired people often need more income in their active early years, less in the middle, then more towards the end, if they need nursing care.
“That U-shaped income requirement is not catered for in UK DC pensions,” he says. But it could be with an annuity which had, say, a capped and collared arrangement, Butcher suggests.
More employers are now opting for contract-based pensions for simplicity
and because of the lower compliance costs.
But, particularly at the start of the payout phase, there can be disadvantages in this hands-off method of workplace pension provision.
Jeremy Williams is pensions manager at the Daily Mail & General Trust (DMGT). On top of the DB scheme, which is now closed to new employees, the DMGT scheme has four contract-based DC schemes, having converted its trust-based DC scheme in October 2007.
Although easing the governance burden and the need for trustees was the main impetus for DMGT in switching to a contract-based arrangement, Williams says that with this type of arrangement, the scheme has too little control over the members’ pensions in the run-up to decumulation.
“It does lessen the load of monitoring but, in doing so, it’s very hard to get visibility on when the employee is retiring, and ensuring that they get their full range of options - it’s the unintended consequence of going contract-based,” he says.