What is the background to the pension freedoms?

Supported by
Scottish Widows
twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Supported by
Scottish Widows
What is the background to the pension freedoms?

That is according to Peter Bradshaw, national accounts director at Selectapension. 

At the same time, annuities were not looked on quite as favourably as they once had been.

He recalls by the time then-chancellor George Osborne made his Budget announcement about removing the need for every retiree to buy an annuity, the annuities market was seen to represent poor value.

“If you went back 20 years ago, an annuity was quite a good thing to have,” he remembers.

So what had changed in that time?

Fiona Tait, technical director at Intelligent Pensions, explains: “For a number of well documented reasons, the income available from annuities was falling and people were being put off pension saving by the fact that they couldn’t access their money without taking all of their income at once. 

“Income drawdown was introduced in 1995 to address this problem. However, due to the associated investment risks the majority of retirees were still likely to end up with an annuity.”

A fall in the income available from annuities in the years before the freedoms had tarnished their image, with the belief that they were the only option available to savers and offered poor value for money.Gareth James

Bernadette Lewis, financial planning manager at Scottish Widows, recalls: “Before the reforms, alternatives to annuity purchase included capped drawdown, or flexible drawdown for those with secure pension income of at least £20,000 a year (reduced to £12,000 a year for new declarations from 27 March 2014)."

"But these forms of drawdown weren’t generally suitable for the majority with relatively low levels of DC pension savings. That left annuities as the possibly unsatisfactory solution for those with too much to qualify for a trivial commutation lump sum, but too little to fund a worthwhile retirement income."

Gareth James, head of technical resources at AJ Bell, agrees the purchase of an annuity had become the norm.

“For most, the retirement saving landscape used to involve building up a pension until they hit their 65th birthday and then handing over their pension pot to an insurance company to provide an annuity for life,” he says. 

“A fall in the income available from annuities in the years before the freedoms had tarnished their image, with the belief that they were the only option available to savers and offered poor value for money.”

Prior to April 2015 when the concept of pension freedoms was introduced, all those with pension pots under a certain size were “frozen out” of the drawdown market, recalls Neil Adams, pensions and investments expert at Drewberry.

While those with pension pots sizeable enough for drawdown were still required to purchase an annuity at the age of 75, he notes.

Political move

The retirement market appeared to be inflexible and wanted everyone, regardless of circumstance and wealth, to conform to the annuity model.

Mr Bradshaw also suggests another problem was the perception that not only were annuities poor value but that the customer was tied.

“Because most people didn’t exercise an open market option, they just rolled over and took an annuity with the provider they had the DC arrangement with, so there was no shopping around,” he says.

Mr Osborne certainly grasped the chance to shake up the pensions industry.

“In 2014, the chancellor spotted an opportunity to address this and to make a politically popular move at the same time within that year’s Budget speech, and announced that people would be able to withdraw their entire pension fund as a lump sum,” Ms Tait says.

“The result is now that anyone who has reached the minimum age of 55 can choose exactly how and when to access their pension benefits, allowing them to use their pension plan to meet different financial needs and to tailor their retirement income to their own personal circumstances.”

The reforms certainly did what they said on the tin, which is to free up pots of money that otherwise went into the hands of the insurance firm who was providing the annuity.

As Mr James puts it: “The freedoms have changed things by removing the perception that annuities are the only option available, and that it is only possible to start taking funds out of a pension at a fixed point in time.

“The changes have reinforced the belief of savers that pensions are their own money and they can make their own choices over what they want to do with those funds.”

Verona Smith, head of platform at Seven Investment Management, believes pension freedoms are a boon for everyone.

The reforms give people more flexibility but potentially introduce more risks and costs.Stephen Lowe

“What pensions freedoms should mean for every single worker in the UK is that they now have clear visibility and choices available to them for their hard earned pension savings.

“No longer are they locked into something called an ‘annuity’, which for many people may be a good thing but everyone should have choices.”

Scott Gallacher, chartered financial planner at Rowley Turton, points out drawdown “may have become more popular anyway, given the relatively low income being offered by annuities”.

“Pension freedoms perhaps just gave it another boost,” he adds.

More choice, more risk?

For many, the annuity remains the best option as it promises a guaranteed income for life.

One of the advantages of the product which made it popular in the first place is it means the retiree can take a step back. Other than to choose an annuity product in the first place there are no ongoing financial decisions to make.

For those who do not opt to annuitise, many in the industry are concerned there are risks.

In the wrong hands, more choice is not necessarily a good thing.

Stephen Lowe, group communications director at Just, acknowledges: “Since the changes, many more people aged 55 and over have chosen to take money directly from their pension funds, either emptying the pension or leaving some invested in the hope of future gains. 

“The reforms give people more flexibility but potentially introduce more risks and costs. 

“The FCA has called accessing pensions early ‘the new norm’, with seven in 10 (72 per cent) aged under 65 and most choosing to take lump sums rather than regular income. Around half of fully withdrawn pots are put into savings or investments.”

But he warns: “The FCA said ‘this can result in consumers paying too much tax, missing out on investment growth or losing out on other benefits’.”

Ms Lewis points out one of the complexities brought about by the freedoms is the Money Purchase Annual Allowance (MPAA).

"The MPAA is an intentional complication introduced along with the reforms in 2015-2016. It was originally £10,000 a tax year but reduced to £4,000 from 2017-2018," she notes. 

"The MPAA restricts DC contributions for all those who’ve flexibly accessed pension income, as an annual allowance charge applies to any excess. The MPAA doesn’t apply to DB schemes, leading to complex calculations for affected active members of both DB and DC schemes."

She cautions that the MPAA restricts tax planning opportunities, explaining: "The MPAA creates traps for those who reject advice or guidance, as taking uncrystallised funds pension lump sums (UFPLS) automatically triggers it, while crystallising via flexi-access drawdown and taking just the tax-free cash does not.

"Some over 55s who’ve used a UFPLS to repay debts are finding the now £4,000 MPAA leaves them unable to rebuild their pension savings as anticipated."

Three years on from Mr Osborne’s announcement and the industry is still trying to resolve the issue around encouraging people to sit up and take notice of their pension.

As Mr James puts it, a need for greater engagement with pensions “is positive for those who are engaged, but has introduced risks for those without the desire or knowledge to engage”. 

eleanor.duncan@ft.com