Personal PensionFeb 19 2015

Reform spells healthy future for advice

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Reform spells healthy future for advice

In the March 2014 Budget George Osborne announced a fundamental reform to the way people access their pensions by abolishing the effective requirement to buy an annuity. The 2014 Pensions Bill also heralds change as it sets out additional options for occupational pensions to share risks.

These changes provide a different regulatory framework for DC pension schemes – in particular, they allow for the transfer of risk between providers, advisers and individuals.

Nest’s current consultation, The Future of Retirement, considers how retirement experience is changing, and the possible implications for DC scheme design.

People’s attitudes towards retirement are changing. We believe that this is due to a combination of factors, including:

 The marked increase in life expectancy resulting in longer retirements, combined with the increased likelihood of needing to fund care during that period,

 the current low interest rate environment offering low returns,

 a growing realisation that the adequacy of retirement provision from the state is likely to reduce,

 a decline in the availability of final salary pensions,

 a move towards more flexible working practices,

 the increased number of single person households,

 the increase in the state pension age, and

 a variety of other cultural and demographic changes.

People are generally retiring later. Retirement has also become less of a definite line in the sand, having evolved into a process in which people’s work patterns vary, and they gradually work less.

Research has shown that many people approaching retirement are worried about their money running out. This concern incorporates volatility, inflation and longevity risks.

When individuals buy an annuity, the risk of running out of money is taken by the provider. The provider will guarantee that the individual receives an income that is stable – or index-linked, if selected – for the rest of his life. Of course, the downside of this approach is that the individual may have such a small pot for his retirement that his income is small. However, there is certainty about what the income will be.

After April 2015, the individual can do what he likes with his retirement pot. The risk of running out of money lies in his own hands. Unless and until, that is, the individual asks an adviser to sort out his retirement finances, at which point the risk is handed to the adviser.

The March 2014 Budget announcement shifted risk from the provider to the individual and – when used – to the adviser.

The 2014 Pensions Bill is to “make provision about pension schemes, including provision designed to encourage arrangements that offer people different levels of certainty in retirement or that involve different ways of sharing or pooling risk and provision designed to give people greater flexibility in accessing benefits”. For example, this may result in defined contribution schemes – where the risk of running out of money in retirement sits with the individual – including longevity insurance in the scheme, so that some of that risk is managed by the provider.

Individuals’ goals and needs in retirement are significantly different now than when the current generation of products were developed. In addition, the changes in the regulatory framework mean that the amount of risk placed with an individual will change, which should have a big impact on the products and advice that these individuals need. Change is clearly needed, and Nest’s consultation is timely as part of a drive to challenge existing thinking and to strive for structures which better meet individuals’ needs.

To reflect changing retirement patterns and provision, DC schemes need to offer flexibility. Individuals want the flexibility to postpone retirement and/or phase pension income, to align with continued participation in work. These are two fundamental ways for individuals to manage the risk that pension income will be less than they require. Flexibility to integrate the Nest pension with other pensions so that the total pension income is level could also be beneficial. Individuals also want to have their money when they need it. In other words, they require flexibility in terms of sequencing. For example, individuals may want a lump sum when they retire to update their house, buy a new car or go on holiday. They may also need an increased income towards the end of their retirement if they need to fund care costs.

It is clear that the next generation of products need to enable ongoing advice. As the circumstances of the retiring individual evolve, their retirement solution must have the ability to adapt, so that they can respond dynamically to changing needs.

Given an individual’s need for certainty in retirement, we expect guarantees to remain in demand for at least part of their solution.

The purchase of an annuity should certainly remain part of retirement planning for DC members. Indeed, annuities are likely to play a continuing role for some individuals due to the guaranteed income for life they provide. However, at least in their current form, they often lack flexibility. Furthermore, while annuities deliver certainty in some regards, an individual’s overall return from an annuity can be highly uncertain, as it depends very much on how long the member survives after the purchase.

The continuing preference by many for some degree of guaranteed income needs to be addressed alongside the rising demand for solutions enabling individuals to address a range of alternative goals – for example, the ability to provide an inheritance. Given this, we expect further innovation in the annuity market as well as the increased use of alternative solutions such as unit-linked guaranteed products.

Other points of note are: the inflation protection available in annuities today (RPI- or CPI-linked) is not necessarily appropriate for pensioners’ spending patterns; and a phased approach to the purchase of income guarantees, through phased annuitisation, fixed-term annuities or deferred annuities, can have some advantages for members in certain cases.

The significance of DC pension provision is likely to grow. The increased reliance on DC might imply a need for increased conservatism in DC investment as members have reduced diversification over their sources of income in retirement. On the other hand, the increased reliance on DC to provide at least some alignment of pre-/post-retirement living standards makes it critical for members to seek attractive returns on their funds for as long, and as consistently, as possible, to avoid dramatic, unexpected changes in circumstances due to market movements.

The new environment provides an opportunity for advisers to help individuals throughout their retirement, and for providers to offer solutions which recognise the changing needs and regulatory environment. This will enable individuals to make better choices which provide improved risk-adjusted returns on their retirement savings and deliver a better overall chance of meeting their goals. The tools and techniques required to deliver these solutions are available now.

Colette Dunn is head of strategy and Russell Ward is a senior consultant at global actuarial and management consultancy Milliman

key points

The Budget changes provide a different regulatory framework for DC pension schemes, including the transfer of risk between providers, advisers and individuals.

To reflect changing retirement patterns and provision, DC schemes need to offer flexibility.

The increased reliance on DC might imply a need for increased conservatism in DC investment.