On the day of the 2014 UK Budget, with a stroke of his pen chancellor George Osborne introduced the biggest change in UK pensions since 1921, the year in which tax relief was first offered to people saving for retirement.
Osborne’s massive liberalisation of pension rules means that from April 2015, subject to consultation, anyone over the age of 55 will be able to withdraw their entire pension pot as cash.
This was a genuine bombshell Budget – nobody was expecting quite such a revolutionary move – and it has turned perceptions of pensions on their head overnight. No longer a savings vehicle that pushes savers towards the inevitable purchase of a poor-value annuity, pensions now offer something everybody likes – easy access to cash.
The reaction to this move has been hugely varied, with passionate voices on both sides.
One school of thought says the whole policy is a moral hazard. People are not interested in pensions and when it comes to making decisions about their fund, they do not have the necessary knowledge to budget for their retirement.
Pensioners find longevity predications hard to believe and consistently underestimate their life expectancy. As a consequence, most savers would much rather have cash now than set it aside for the future. Research from PwC reinforces this sentiment, revealing that in markets where people have free choice over their pension pots, more than 70% opt to take the cash.
The opposite view, as championed by Osborne, is that people who have worked hard and saved up should be treated like grown-ups and allowed to use their money as they wish, rather than be patronised by the state – the man in Whitehall does not always know best.
The pensions minister, Steve Webb, insists he is relaxed about people potentially taking all their retirement fund as cash. He says: “If people do get a Lamborghini, and end up on the state pension, the state is much less concerned about that, and that is their choice.”
From my perspective, there is some force in both arguments. It feels counter-intuitive that we are currently in the midst of introducing automatic enrolment into workplace pensions, precisely because of the belief that only inertia will get people saving; and yet when it comes to retirement, pensioners are expected to become engaged and informed overnight. On the other hand, anything that encourages pension saving has to be a good thing.
Regardless of which side of the fence you are on, there is one universal truth upon which virtually everyone agrees – the annuities market is broken. It offers savers poor value, it is uncompetitive and some of the large players have become complacent.
Having said that, reports heralding the demise of the annuity have been overblown. Even the pensions minister commented post-Budget that these announcements would “not result in the death of annuities altogether”. He is quite right.
Even though £4.4bn (€5.3bn) was wiped off the market capitalisation of the life insurance sector on the day of the announcement, many people will still be attracted to annuities. They provide a guaranteed income and dispose of the risk that you might outlive your resources.
But the nature of the annuities market will change. Transparency will improve and consumers will shop around. Logic suggests this should improve the competitiveness of the product. However, one of the potential unintended consequences highlighted by the Institute for Fiscal Studies is that people who want to buy an annuity in this new market are more likely to be those who expect to live a long time. Insurance companies could respond to this shift by reducing annuity rates.
With consumer behaviour set to change drastically, the challenge now exists for the pension industry to develop a more varied range of options for drawdown, annuitisation and reinvestment of lump sums. There will be huge appetite for products that offer a predictable return but with limited risk to capital, and this provides significant scope for innovation.
The success of this policy ultimately hinges on advice – people must be given the right information to allow them to make an educated decision.
The chancellor has made a commitment that everyone nearing retirement should receive “free, impartial, face-to-face advice on how to get the most of their choices”, and has set aside £20m to deliver this.
PwC believes Osborne is underestimating the scale of the task. This year, about 400,000 people will need to decide what to do with their defined contribution (DC) pension pots. If every retiree were to receive face-to-face advice, 400,000 extra hours of guidance would be necessary, with an additional 500 suitably qualified people needed to deliver it. PwC estimates the cost of this would be closer to £120m.
This suggests that what the government has in mind is a guidance service rather than regulated advice from a fully qualified adviser.
But watering down the proposals would be unwise. In years to come, the government could find itself in a US-style predicament, where the majority take the cash, move to Florida and eventually run out of money. The government would then have to pay more out in benefits to pensioners living on the breadline – something auto-enrolment was designed to avoid.
Few would disagree that a shake-up of the pensions decumulation market is long overdue, but are we looking at this through the wrong end of the telescope? Having plenty of choice with what you do with your pension pot at retirement is all well and good, but if your pot isn’t big enough your options will be limited anyway. What matters most is how big a pot is accumulated during your working life.
Data from The Pensions Regulator shows the average size of a DC pension pot is £25,000, making the dream of a Lamborghini just that.
Against the backdrop of a chronic decline in DC pension saving, the number of people saving into an occupational scheme has fallen by about 500,000 since 2010, and the government cannot afford to lose sight of the importance of encouraging long-term saving.
Auto-enrolment is a significant step in the right direction, but measures designed to improve scheme quality and reduce charges should not be forgotten. During a lifetime of saving, charges can have a significant impact on final fund values.
In addition, the current combined contribution of 8% – the legislative minimum for auto-enrolment – will not be sufficient to ensure a comfortable retirement, and the government must consider increasing the minimum contribution over time to prevent disappointment when savers come to draw their pension.
Either way, Lamborghini dealers needn’t expect a rush through their doors anytime soon.