Less nudging, more shoving

Several recent surveys have asked people about their intentions for their defined contribution retirement savings. The recent Aon DC Member Survey found that nearly 70 per cent expressed a desire for a “steady, secure income” in retirement, without the risk of outliving their savings – that is, a lifetime annuity, although it is rarely described as such.

A report from the International Longevity Centre-UK think-tank found that the majority of DC pot holders aged over 55 want a guaranteed income for life, particularly an income protected against inflation. It also found that only 50 per cent of people understood how to obtain this from their pots: the word ‘annuity’ does not resonate.

Abroad, there is a growing disenchantment in some developed countries – notably Australia and New Zealand – with their lack of an annuitisation culture. Fortunately for the UK, these countries have been running control experiments on our behalf, albeit unwittingly: we have much to learn from them.

It would appear that most people do not appreciate that an annuity is a pension. In addition, when it comes to insuring against longevity risk (the risk of outliving our assets), there is no directly comparable product. This, combined with the rapacious behaviour of some within the financial services industry, is an open invitation for today’s situation concerning annuities: market failure. But this does not mean that annuities per se are the issue.

The politically astute 2014 Budget sent a shock wave through the retirement savings industry. By ending the obligation to annuitise pension pots, it sowed concerns that the socialisation of longevity risk, in particular, may not have a future. Annuity providers suffered accordingly, accompanied by growing concerns that many individuals will ultimately also suffer.

The Pension Wise guidance service is intended to mitigate such concerns, but there is a risk that it will disappoint. It is not intended to deliver what people want, which is advice as to which specific transactions to execute, and with whom.

Indeed, the distinctions between ‘guidance’ and ‘advice’ are very hard to grasp; they are certainly not intuitive. Even if a definition could be agreed upon, it is likely to be so nuanced as to be nigh impossible to communicate simply.

The confusion is reinforced by the existence of the word ‘advice’ in the name of each of Citizens Advice Direct and The Pensions Advisory Service, and the much-derided Money Advice Service, none of which can give ‘advice’ as it is understood by the industry.

After an initial guidance contact with CAD or Tpas, many people are likely to wallow in decumulation indecision

Consequently, after an initial guidance contact with CAD or Tpas, many people are likely to wallow in decumulation indecision. Some will take lump sums, which invites the risk of running out of money before death (perhaps to fall back on the state), and others will succumb to fraudsters.

People approaching retirement need to be encouraged to purchase retirement income products that limit downside risks, notably longevity, investment and inflation risks that almost all of us are incapable of managing by ourselves.

Consequently, auto-enrolment should be complemented by the introduction of a decumulation default: auto-protection, tied to the private pension age (today, 55). DC pension pots would be converted into pensions, joint-life for married savers and ideally inflation-linked.

In addition, those who accept the default pension but defer taking it until at least five years after the private pension age should be rewarded with a pension exempt from income tax, paid for by a reduction in up-front tax relief.

The guidance guarantee could form an integral part of the auto-protection process, to aid selection of the most appropriate form of pension (including determining eligibility for health-related enhancement) or, indeed, whether to opt out altogether.

Meanwhile, we are tiptoeing around a major issue, rarely discussed. Ideally, auto-protection should come into effect at 60 or 65, but following the 2014 Budget’s liberalisations, the genie is out of the bottle.

For now, we are stuck with today’s private pension age (currently 55, rising to 57 in 2028), an anachronism that is out of step with post-war improvements in life expectancy. It should be rapidly raised to 60 in 2024, that is, by a year every two years, commencing in 2016. In addition, politicians should be preparing people for 65 by 2030/35.

It is time that we confronted another inconvenient truth: by offering tax-free status on the first 25 per cent of a pension pot, we actively discourage people from securing a pension at the age of 55. This is daft, when the alternative is a pension 33 per cent larger than otherwise, which would help mitigate the risk of running out of money in retirement.

In addition, as an incentive for long-term saving, it is wholly ineffective. Ideally, the 25 per cent tax-free lump sum should be scrapped (with accrued rights protected), which would be perfectly justifiable given that recipients would have already received up-front tax relief on their contributions. Given political sensitivities, access should first be pushed back to the age of 60 or 65.

As a prerequisite to introducing auto-protection, the annuities market which underpins pensions requires radical reform. It is clear that nudging – such as that given by the Open Market Option – has not worked: it is time to start shoving.

A not-for-profit national auction house for annuities should be established, with mandatory participation by all aspiring annuity providers. This would be akin to making the exercise of the OMO mandatory, automating the process of shopping around, adding to pricing tension and transparency.

Initially, only a limited number of standardised single- and joint-life, inflation-protected lifetime and deferred annuity contracts should be listed. Pre-auction bundling of small pots by the house would introduce efficiency and scale, also encouraging stronger bids.

The annuities that would underpin auto-protection’s default-derived private pensions would be executed through the auction house. In addition, the Treasury should be permitted to participate, writing annuities as a funding alternative to the gilts market. Then, perhaps through agents, it could offer default private pensions as Post Office Pensions and national savings pensions.

Auto-protection would ensure that savers reaching the age of 55 are not left to wallow in indecision when pondering the complexities of decumulation. To the extent that people went with the default of a pension, preferably deferred, the risk of running out of money before death would be reduced, as would the risks of exposure to pot conversion fraud and moral hazard.

Auto-protection could also be incorporated within collective DC schemes to encourage the collective hedging of individuals’ exposure to the unquantifiable risk of longevity, and the uncertain outlook for investment returns and the cost of living. Through harnessing economies of scale, and risk pooling over generations, larger pensions could result.

To be clear, everyone would be free to opt out of auto-protection to pursue alternatives, consistent with the liberalisations announced in the 2014 Budget. There is no desire to prevent people doing what they wish with their own savings.

Michael Johnson is a research fellow of the Centre for Policy Studies

Key Points

In some developed countries there is a growing disenchantment with their lack of an annuitisation culture.

After initial guidance contact with CAD or Tpas, many people are likely to wallow in decumulation indecision.

It is clear that nudging has not sufficiently reformed the the annuities market.