PensionsJan 21 2015

Paths to freedom

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Paths to freedom

A pensions system which has stayed largely unchanged since 1911 will now give way to one where consumers have far greater opportunities to access their pension savings. This is extremely popular.

The real challenge will be how to make these freedoms work in practice, given that how one chooses to invest one’s money over a potentially very long retirement is extremely complex. Indeed the Pensions Policy Institute rated this as the hardest informed financial decision in adult life.

Implicit in the new freedoms is the responsibility which rests with it. The buck stops with savers, now turned investors. If they run out of money before they die, it is their fault.

The scale of this challenge should not be underestimated. PPI finds that decisions about accessing defined contribution pensions are difficult as they often require understanding of “complex and uncertain concepts such as inflation, investment and market risks and longevity risk”. Add the implications for tax, dependants, long-term care, product diversity and guidance, and financial advice could not be more important.

What can we expect to see on Pensions Freedom day? We can expect a functioning Pension Wise guidance service including a website. Although I anticipate this will be rudimentary at outset it will evolve significantly over time. The government will seek to avoid an ‘Obama-care’ style meltdown at all costs as almost 2m potentially access the service.

Guidance service take-up has been estimated between 2.5 per cent (from initial Legal & General testing) to 92 per cent (CII). The reality, I suspect, lies at the 25 per cent mark with an additional 25 per cent directly to financial advisers. Engagement with the guidance service and financial advisers, in particular, will offer better outcomes for those who in the past may have defaulted through inertia into inferior annuities from their providers.

What products will consumers purchase? Research offers a few clues. Research suggests 36 per cent will put their money into bank accounts. This exposes consumers to the risk that inflation and charges will erode their savings over time. The banks, spurred by the revelation that pensions have now become a ‘retirement bank account’ may develop eponymous services, perhaps with ‘hole in the wall’ facilities to meet greater demand. Regulatory and compliance risks will be significant.

Almost half (43 per cent) would invest in a savings bond or other product to ensure their capital was safe. Again, a spur to banks and investment houses to develop these products. The issue here is that they must be sufficiently simple to understand including the many risks which could be associated with them. A logical successor to these freedoms would be the development of new Super-Isas which can be annuitised. Isas are simple to understand and are popular. Strong take up may result in major US and Australian investment houses and asset managers showing greater interest in this market.

About 23 per cent said they intended to purchase an income generating asset. An example of this is buy-to-let. There are countless examples of the risks of doing this for the unwary - however few will have enough savings to purchase these properties outright.

Then, of course, there is drawdown. These are great products for those who understand the risks. For those with limited savings, Age UK’s recent report highlights that, based on life expectancy for 65-year-olds (over 83 for men and just under 86 for women) even modest withdrawals would quickly deplete people’s savings - offers a salutary warning for the uninformed. Again, good financial advice is everything.

What about the insurance industry? I believe many providers will develop hybrid solutions which combine a guaranteed income underpin with flexibility and growth potential. Australia’s Murray Review recommended “a comprehensive income product in retirement” which provided a regular and stable income stream, longevity risk management and flexibility not only because it could increase private incomes for many in retirement but because this would provide them with peace of mind that their income will endure throughout retirement.

Will the annuity survive? Yes. Many were resistant to a combination of the compulsion and poor rates offered in an inefficient market. These rates were eroded by QE and ever-increasing life expectancies. I believe the pensions freedoms have accelerated an inevitable move towards individually underwritten annuities. The outlook for standard annuities must be bleak, although for enhanced annuities which typically offer 20 per cent more for those with health or lifestyle conditions, they will still be important in an altered market. I expect many to defer purchasing annuities and possibly will do so in a phased way; however when they do so they will be older and likely to qualify for better rates.

We must not forget that many people want the peace of mind of a secure, guaranteed income in retirement. Recent research by the International Longevity Centre-UK among 5,000 consumers showed that “Seven out of 10 people with defined contribution pots aged over 55 would prefer pensions to deliver a guaranteed income for life.”

But how will people actually react in April? Many will be very confused by the growing choice of products. Some may fall prey to pension ‘scammers’. A combination of the choice and scale of the issues pensioners are facing also leads to the risk that many simply default into whatever product their provider offers them, without first engaging with guidance or advice.

This will hopefully stimulate regulators to take calls for a ‘second line of defence’ seriously to make sure maturing pension providers have to perform checks to prevent customers buying or defaulting into unsuitable or unsuitably expensive products. I also hope regulators explore ways to enable advisers to provide cost-effective simplified advice models which provide good outcomes for the majority, without the fear of financial penalties because by definition they cannot guarantee ‘perfect’ outcomes for everyone.

Many will simply recognise they lack the savings to have a comfortable retirement and those who can, will seek to work for longer.

Others will have to pay off debt, particularly the thousands with endowment and interest-only mortgages. Research showed more than half a million 40 to 70 year olds in England intend to use part, or all, of their pension to repay their mortgage balance. This cohort are at risk of being targeted to take on increased debt in advance of retirement, in the knowledge that retirement funds can be accessed to meet liabilities.

Of course, many will be tempted to take their entire pot out as cash. Bristol-based Hargreaves Lansdown has estimated that 200,000 people will take their entire pension pot out. Of this it estimates 20 per cent will spend it on a holiday, 12 per cent are planning to spend the money on DIY and 8 per cent plan to buy a car. This will provide a welcome surge in consumer sales, goodwill and a tax windfall for government in advance of the May election.

However the priority for many must be to secure the essential costs of retirement. Research into a provider’s customers in 2012 demonstrated that more than half of those surveyed spent the additional money from their “enhanced annuity” on food bills, heating and electricity, and generally on paying for their cost of living. Although this is not glamorous – it is extremely important and should be the cornerstone for all retirement planning.

The industry, regulators, government and increasingly consumers must work to ensure that the freedoms provide better outcomes for pensioners. The stakes are too high not to.

Jim Boyd is corporate affairs director of Partnership. The views expressed are his own.

Key points:

Under the new freedoms the buck stops with the saver, now turned investor. If they run out of money before they die, it is their fault.

Many providers will develop hybrid solutions which combine a guaranteed income underpin with flexibility and growth potential

Many will simply recognise they lack the savings to have a comfortable retirement and those who can, will seek to work for longer