Don’t spend it all at once

He did not of course know about pension freedoms, but it highlights a key challenge in explaining the ability to defer gratification to earn rewards with which the retirement income market will have to grapple.

Academics have put the concept into practice: last year researchers in Sweden conducted a study among 13,000 13-year-olds who were offered the choice of the equivalent of US$140 now or US$1,400 in five years’ time. Reassuringly the better-educated 80 per cent were willing to wait, but one in five still chose instant gratification.

Florida lottery winners illustrate the pension freedoms dilemma perfectly – Powerball, Lotto and Mega Money winners are offered the choice of a lump sum or an annual payment. Between December 2009 and June 2013 just five of the 148 winners took the annual payment, preferring instant gratification.

Unfortunately after five years, 70 per cent of winners had spent the whole lot. Research does not show how good a time they had, but it does prove that certainty over income makes your money last longer.

The launch of pension freedom is not a lottery win for anyone, but commentary has focused almost exclusively on the rise in flexibility with the annuity being swept away. Even the 5m-plus customers who have annuities are going to be offered the chance to join in.

Challenges

The point is that pension freedoms are creating a new set of challenges. We all know the old fixed retirement date and traditional ‘cliff-edge’ of retirement has crumbled. People are working and living for longer, and need more freedom and flexibility on how they take their retirement income.

The risk is that flexibility has to be balanced against certainty over income in retirement to ensure savers do not struggle financially when they should be enjoying a comfortable retirement. The challenge for the industry will be to ensure that there are safeguards in place ensuring people a guaranteed income. Innovation is crucial, but it must have a purpose, and build on the best of the old.

The long-term declines in annuity rates, combined with the perceived inflexibilities, have been key factors making annuities unpopular among many advisers and savers. However, they did deliver security of income.

Drawdown of course offered an alternative, with people choosing the drawdown option being generally those with larger than average pots – currently the average fund size in the drawdown market is around £150,000. In 2013, the lowest pot size most providers would accept was £50,000, meaning that the vast majority were forced to buy an annuity.

They chose annuities without advice. Research from Spence Johnson shows that advised annuity sales fell from 68 per cent of the whole market in 2012 to 48 per cent of it in 2013. The gap created by the withdrawal of advisers made room for new intermediaries such as online brokers. They fulfilled a demand, but clearly people are not being advised as much as they need to be under the new pension freedoms.

Flexibility has to be balanced against certainty over income in retirement to ensure savers do not struggle financially

The drawdown market remains heavily advised, but the growth of the internet and the greater availability of online tools and information present a threat to advisers’ traditional role, allowing some pensioners to choose a DIY approach to selecting their retirement income products. However, with more freedom comes responsibility, which is why the role of financial advisers will become even more important for retirement planning.

Guarantee

Solutions that convince people not to simply ‘take the money and run’ will require some form of guarantee. As pension freedoms are introduced it seems likely that products offering some form of guarantee – at least of the capital invested if not the income – will be required to convince them to choose a retirement income product over simply holding onto their pension pots as cash.

Spence Johnson estimates annuity reserve assets are almost four times the size of the total drawdown market. They believe that outside the pensions markets, stocks and shares Isas remain a significant source of retirement income assets, providing pensioners with larger pots with a tax-free vehicle for their cash, which creates a way for pensioners to pay no tax on both their pension lump sum and the future growth of that lump sum.

Those with larger pots tend to have access to a wider range of investable assets – including in some cases commercial property held within a pension wrapper, making funds a smaller part of their overall portfolio. Those with smaller pots tend to use insured individual pensions, annuities and Isas. Overall the drawdown market is heavily invested in funds and fund-based products, especially when it comes to smaller pot sizes.

Analysis suggests that for those with smaller pots the great majority of their pension assets in drawdown are invested in yet even smaller pots. This reflects the more limited range of options offered to those at the lower end of the drawdown market, with most personal pensions and simple Sipp wrappers offering access only to a limited range of fund options.

The variable annuity market has existed for more than 15 years in the US, and is a popular, mainstream option for many people approaching retirement. In the UK it has evolved into guaranteed drawdown, and has grown in popularity as these products seek to provide pensioners with a complete solution that blends continued exposure to investment growth, with a form of protection either through full guarantees or, failing that, volatilitycontrol or dampening techniques.

There is every reason to believe that guaranteed drawdown could deliver similar benefits to UK pensioners, as these products mitigate longevity risk while offering more freedom and flexibility than conventional annuities.

The need for certainty is even more important in the new world of retirement planning and, as the UK goes through its pensions revolution, there are lessons to be learned from around the world.

Australia

Other countries which have launched similar rule changes to the UK, such as Australia, are now reverting to the old system as concerns rise about people running out of money, highlighting the importance of capital and income guarantees. With pensioners spending longer in retirement, there will be an increased requirement for retirement income solutions capable of supporting them for a significant number of years.

A solution which combines the best of both can help savers in the new regime – certainty over income is important as people fear running out of money, but many are also unwilling to take risks. We believe capital and income guarantees are ideally suited to meet the challenges presented by the new pensions freedoms. Spence Johnson forecast the market for guaranteed drawdown will grow from around £1bn a year in sales to £48bn in assets invested by 2023.

Innovation

Guaranteed drawdown delivers an income for life no matter what happens to markets and no matter how long customers live. Therefore we expect more providers to innovate in this space, and as the market develops a wide range of new solutions is likely to be launched. However, any innovation will need to embrace both flexibility and guaranteed income.

Swedish 13-year-olds, Floridian lottery winners and Australians can all teach us some lessons. Of course the UK will learn its own lessons and have its own experience – but it is guaranteed that instant gratification is not the way ahead. Homer Simpson might dis-agree, but Homer the poet was right all along.

Simon Massey is wealth management director of MetLife UK

Key points

Research suggests that when people come into some money, many of them opt for instant gratification.

In pensions freedom, solutions that convince people not to simply ‘take the money and run’ will require some form of guarantee.

There is every reason to believe that guaranteed drawdown could deliver benefits to UK pensioners.