UK: The DC information gap
The growing significance of defined contribution pensions means trustees should be prepared to serve members with better information on retirement income options, writes Ros Altman
Are members of UK defined contribution pension schemes being let down at retire-
ment? Trustee duties for member protection are not limited just to the accumulated pension fund. Surely they should also encompass giving members good chances to optimise their retirement income.
A recent survey of major employers, conducted by Wealth at Work found that only 13% know they do not have to buy an annuity with their pension savings. Indeed, trustees often signpost members to an annuity broking service on retirement, even though annuity purchase may not be appropriate. This could mislead members into receiving poor value for their retirement savings.
Annuities are complicated, inflexible and irreversible and may be unsuitable for retirees, especially those with small defined-contribution funds in company schemes. However, the many drawbacks of annuities are currently being overlooked, as the emphasis focuses almost exclusively on exercising the open market option at retirement.
The standard annuity offered to retirees is a single life, level payment. But just ‘shopping around’ for the best rate for this annuity is insufficient to optimise retirement income. It is vital to buy the right type of annuity too, not just get a good rate for the wrong type.
Unlike the pension from a defined benefit scheme, which offers automatic spouse cover and inflation linking, standard annuities have no protections of this kind. Those with a partner will often want a joint-life rather than a single-life product, but as this pays a lower starting income, people need help to understand the implications for themselves. Annuity pricing is not straightforward.
Strict regulatory reserving requirements mean providers who have sold large numbers of annuities recently may drop their rates to discourage purchases, as they have insufficient reserves to back new sales. Even companies that have regularly offered ‘best buy’ rates in the past may not have the most competitive current rates. In addition, new entrants come into the market from time to time, offering better rates, so it is important to access the whole market. Annuity brokers often exclude certain providers, however. At the current exceptionally low rates, annuities may not protect pensioners from many of the risks they face during their retirement.
Standard annuities pay the highest starting income and are therefore the most often chosen, but provide no inflation protection and no cover for a partner. Annuities also offer no protection against the risk of dying early. Even with a 10-year guarantee, if the pensioner dies relatively young, the insurer keeps around half their pension savings while their family lose the rest. Standard annuities will not protect against the risk of worsening health. Those who buy enhanced annuities because of an existing health issue may even become more seriously ill. If they had waited, they could have received a much better rate, but once bought, the insurer will not make any future adjustments for deteriorating health.
Furthermore, annuities offer no protection against the need to pay for care in later life. There is no contingent income payment that would offer higher payments to cover care costs if someone becomes seriously ill.
Buying at current rates offers no opportunity to benefit if rates rise from current artificially depressed levels. Of course, rates might continue to fall, but from today’s low levels rate rises are far more likely than further falls over the longer-term.
Equally, pensioners whose money has all been locked into an annuity cannot benefit from rising markets to earn extra investment returns. Indeed, since QE is designed to improve asset prices by keeping rates low, buying annuities at current artificially depressed rates may mean the worst of both worlds – members are locked into low rates with no chance to benefit from rising asset prices.
In fact, the specific risk with which a standard annuity will help is the risk of living longer than expected and using up all accumulated savings. People buying an annuity are effectively largely betting on this risk happening to them. However current pricing assumes average annuity purchasers will live to age 90, so those who die before that (which will be the majority) will receive poor value. Normal investment advice would be to ensure diversification to help reduce risk. However, when it comes to retirement, consumers are directed to put all their eggs in one basket – the annuity. Particularly when rates are so low, annuitising may increasingly be a sub-optimal choice for someone who is
only 60 or 65. They may be better off waiting until they are older before locking into the annuity, in case their health deteriorates, their other circumstances change, or in case interest rates rise.
But most people do not realise this and if they believe they must buy an annuity they will do so without making an informed decision – especially if their trustees send them to an annuity broker at retirement.
It is important to recognise that, even with small funds, advice is required to assess if annuitisation is appropriate. For example, if a small DC fund supplements defined benefit provision, or is based from AVCs which supplement other income, the member may be best advised not to annuitise and leave the money invested. If they die before age 75, the whole fund passes on tax-free, whereas once they have taken tax-free cash or moved into income drawdown, any unused funds face a 55% charge on death. Members not requiring income from a small pension fund should often just leave it invested. A 65-year-old with a £10,000 pension fund would only receive about £11 a week from a standard annuity, whereas leaving the money invested could deliver far more income later – or allow them to pass the fund on tax-free if they die.
Members need to know they have more flexible options than just annuitising all their funds immediately on retirement. Trustees who send members to an annuity broker do not ensure they are properly informed. They need to understand the benefits of phased annuitisation, rather than committing all their pension savings at once, or investment-linked or guaranteed annuities, and income drawdown, or not annuitising at all for now.Trustees have a responsibility for their member›s best interests but, too often, there is more emphasis on the defined benefit pension, while DC accruals – especially if fund sizes are small – are not treated with the importance they deserve. Best practice includes much more than using an annuity broking service.
Dr Ros Altmann is an independent pensions expert and a former UK government policy adviser