Navigating reforms is a risky business

The Budget announcement changes the landscape considerably for all DC policyholders and the actuaries developing new products for them. In the current environment DC policyholders wishing to retire have very little choice.

They know they have to take an annuity, unless their pots are below the de minimis levels, or are above perhaps £150,000 where drawdown is already available, and the only real freedom or choice is which annuity provider is the most appropriate.

However, as the FCA’s thematic study on annuity sales practices has revealed, many consumers do not shop around and switch provider, even when a high proportion of these would be better off doing so.

In our view even this limited degree of choice represents a challenge for quite a high proportion (the FCA thematic review in December 2014 suggested maybe 60 per cent) of retiring policyholders and they do not bother, or do not know how, to research the market to seek better rates or even explore whether, if in poor health, they might get a specialist impaired or enhanced annuity.

While annuities have had a bad press from regulators and commentators alike they have acted to remove all risks around investments, longevity, tax and the associated costs from the policyholder. Insurance providers and their actuaries have taken responsibility for all of these and have been required to provide additional capital to support these payments even if conditions are adverse.

In the new world there would appear to be risks all round for policyholders, and new risks for insurance providers and their actuaries. Probably the most fundamental risk for all parties in the retirement process at this stage is sheer lack of knowledge and certainty about what is available, what is legally permissible and what the regulator(s) expect.

We have now seen the launch (in “beta mode” – so still under development) of “Pension Wise” (www.pensionwise.gov.uk) the Treasury-developed website to assist pensioners to make decisions about what to do with their pension pot. The website sets out six steps to follow, which we have considered to see how and where the main risks that actuaries would need to assess might arise:

Check list

These are:

1) check the value of the pot;

2) understand the options at retirement;

3) plan how long the money needs to last;

4) work out how much income they will have in retirement;

5) be aware of the tax implications;

6) shop around for the best deals

These steps sound quite straightforward at first but once you dig underneath the surface the risks start to emerge.

Step 1) should be reasonably easy for a defined contribution pension pot, you would think – the insurance company should provide details of the estimated value of the pot based, hopefully, on a recent valuation date. One or two issues will need to be explored here, however. This value will not be guaranteed and it will vary in future depending upon the investments the policyholder has selected. So the first area of risk to explore will be how volatile are the current investments and to what extent is the estimated value likely to change – up or down – in the period until the selected retirement date. Second, the value of the pot may not tell the whole story – there may be valuable options attaching such as, in some older pension policies, guaranteed annuity options which will give a very favourable annuity rate for the policyholder in today’s conditions.

Step 2) is now far from straightforward. The FCA’s thematic review found that 60 per cent of retiring consumers “were not switching providers when they bought an annuity, despite the fact that around 80 per cent of these consumers could get a higher income on the open market, many significantly so”. The Pension Wise website suggests four main options – do nothing; take an annuity; take flexible income; and take cash. The guidance then suggests that the policyholder goes back to their insurance provider to find out what options are available from them. For actuaries getting to grips with the new process this represents a new risk – that of falling foul of the quite subtle regulatory requirements to provide the relevant information but not obscuring the availability of “guidance” such as that provided by the Pension Wise website. There must be risks here that pensioners will not look more widely and will not get the best deal for themselves – as supported by the FCA thematic review finding that many policyholders would have been better off finding a higher-income deal by looking across the market. This issue of course gets picked up in step f), but we have highlighted this to show how easy it might be for policyholders to take the route of least resistance and end up worse off. Also at this stage the options around whether or not to take a tax-free element emerge.

Step 3) is perhaps one of the biggest areas of uncertainty and risk for actuaries and policyholders in the entire process. How long is a pot of money likely to last? With an annuity the income is guaranteed to last as long as you live. We expect that a reasonable proportion of prudent, cautious middle-ranking policyholders will still like and indeed prefer the certainty afforded by an annuity. Of course, many will like the concept of a flexible income which they can manage over their lifetime, but assessing how long the pot will last depends upon at least two key unknowns:

• how long will the policyholder live; and

• how much income will the pot generate year by year?

Behavioural economics tells us that people generally underestimate how long they will live – perhaps based on the experience of older generations – and they will be over-optimistic about how much income their investments will produce, or how stable it will be going forwards.

I believe there are significant risks here whereby policyholders could make poor choices unless they get access to good advice. Actuaries need to highlight these risks and try to give helpful information to assist in the decision-making process.

Step 4) involves considering what other income sources are available and how much the pensioner needs (or wants) to receive in order to sustain a certain standard of living. Here, step 3 obviously interacts, as the policyholder will need to be clear on whether or not the income stream from their pension pot is fixed (as an annuity would be) or whether it has the prospect of fluctuating widely or even being exhausted if the policyholder lives too long. Again, actuaries need to be alive to this new information need and find creative ways to inform pensioners.

Step 5) considers the tax implications. This is, of course, far from straightforward and an area where good guidance and advice will be very important as it will be easy to get this wrong. For example, policyholders who have a desire to buy a Lamborghini with their retirement pot should be made aware that such a car (low mileage, one careful owner) could cost £200,000. So to afford one you are likely to need a pension pot in excess of £350,000 (at a marginal tax rate of 45 per cent) and they should be content with paying the taxman as much as £150,000 for the pleasure.

Perhaps a more common reaction will be to try to minimise the amount of tax to be paid – but that would mean restricting the level of income each year to relatively low levels (£10,000 for 2015/16 tax year). This is a difficult area indeed and one in which it would appear to be very easy for policyholders to misunderstand some of the nuances or for advice to be insufficiently detailed.

Step 6) yields more challenges. We are quietly confident that the actuaries at each and every insurance provider that has been actively operating in the annuity market will be developing a new flexible income product. However, few have as yet revealed what this will look like in detail. So for advisers and pensioners alike we expect that there will be a large number of similar though all slightly different products to try, compare and contrast and evaluate which of them might be most suitable given the individual circumstances of each pensioner. Actuaries will need to provide clear information in a simple format highlighting the key features of their products.

The landscape has changed with the chancellor’s bombshell last March. For policyholders, actuaries, and providers there are still more mines to be found and navigated in this complex regulatory and fiscal landscape.

Tim Bateman is a partner at accountancy firm Mazars

Key points

The Budget announcement changes the landscape considerably for all DC policyholders and actuaries.

While annuities have had a bad press from regulators and commentators alike they have acted to remove all risks around investments, longevity and tax.

There are significant risks here for policyholders to make poor choices unless they get access to good advice.