The Work & Pensions select committee, under the chairmanship of MP Frank Field, recently published its recommendations arising from their inquiry into pension freedoms.
It is not clear how well pension freedoms are working. Although there is a lot of data and information now becoming available about how people are making use of their defined contribution (DC) pension pots, under the flexibilities introduced in 2015, it is still not clear how well the reforms are working. Indeed, as the committee notes, it is not entirely clear just what the government objectives for the flexibilities are, which makes it hard to judge if they are being met or not.
While we know a reasonable amount about what is happening to individual products – how many and how much is being taken out in lump sums, being used to purchase an annuity or moving into drawdown products – we know little about how this plays into the overall finances of people.
For example, how many have more than one DC product and what are they doing with the others? How many have defined benefit (DB) pensions as well? How many have partners with other DC or DB pensions? What other wealth – such as housing wealth – do they have?
But in the evidence we have there is cause for concern about some of the decisions being made. Many are being made without advice – and the FCA has expressed concern about the number of people entering drawdown products in order to access a lump sum, without necessarily being aware of the consequences or the investment risk in such products.
Key points
- The Work & Pensions select committee recommendation supports having a default decumulation option.
- Many decisions at retirement are being made without advice.
- Inertia is a powerful force among savers.
Reckless conservatism
At the other end of the scale there are also worries about reckless conservatism, with money withdrawn from pensions – and taxed as income – to be placed in bank and savings accounts. Many of these are for relatively small sums, reflecting the current relative importance of DB and DC pensions – DC is still, for those currently approaching retirement, on average a smaller part of retirement savings than DB.
But over the coming years this balance will change, with DB declining and automatic enrolment increasing both the numbers of people with DC and the amount of money in pots. So ensuring the system of moving from building up DC pots to spending them works well for everyone is becoming increasingly important.
One of the reasons why automatic enrolment has been so successful so far in increasing the coverage of DC pensions is the use of defaults, based around inertia. If an individual chooses to do nothing, they end up in a well regulated and governed pension scheme with a suitable investment strategy, including contributions from their employer and the government. It provides a zero engagement platform on which to build.
But pension freedoms currently make no allowance for inertia. There are no defaults, other than the money staying in the pension pot. If people want to access it they have to make a decision.
As is pointed out in the select committee report, this means that individuals can build up a pension with no engagement, but may well need high levels of engagement in order to access that money in a way that works for them.
This is not necessarily a problem, provided there is a way of increasing engagement from the time that people start saving until the time they need to start spending. But is it realistic for this to work for everyone?
It is unlikely that, in the current pensions landscape, everyone will arrive at the point of retirement (or potentially before as more people combine part-time work, caring and taking pension income) well enough informed and engaged to know what they can do, and want to do, with their pensions.
So the challenge is to either engage them at that point – through guidance, information and advice perhaps – or to ensure that if they do not engage they can still deliver them a good outcome.
Borrowing from automatic enrolment, the select committee (among many others) recommend the use of defaults at retirement to help protect those who do not engage. There is plenty of evidence, from Pensions Policy Institute (PPI) research and others, that engaging individuals in pensions at any stage is not an easy task.
Working against inertia
The great strength of defaults is that they work with inertia. Doing nothing results in something positive. And for many individuals just knowing that there is a safety net will be a comfort. But defaults are not necessarily easy, and do not always provide the best outcomes.
It is generally possible to take any default, and for any individual do something that improves that individual’s outcome. But this misunderstands the purpose of defaults, which is to avoid the worst outcomes rather than to provide the best. In a world of fully informed and active individuals, defaults have little value. But in a world of inactive and less well-informed individuals, defaults can be very valuable.
Creating defaults does not mean giving up on engagement, the two approaches are not mutually exclusive. Rather, like in automatic enrolment, a default creates a foundation that engagement can build upon. As with any pension policy, there are always positives and negatives. One of the key challenges facing default retirement pathways is the design – what features should a default have? What combinations of lump sum, drawdown, guaranteed income? How do you ensure suitability, and value for money?
Who is a “core customer”? In a way these are very similar issues to those faced by automatic enrolment that have led to changes over time in regulation, charge levels and governance. The select committee is clear that defaults should be low cost, and with a level of governance provided by independent governance committees.
And while it is important the defaults are not compulsory – individuals are free to choose to do something else if they wish – the power of inertia should not be overlooked (just look at the experience of automatic enrolment), nor the potential for a default to become synonymous with the “right” outcome. That is why defaults might have a role alongside guidance and advice, rather than instead of these measures.
Default pathways
Will there be default retirement pathways? There appears to be a head of steam behind the idea, not least from regulators as well as some providers. It is clear that the landscape for the use of DC pensions in retirement will evolve considerably in the coming years, as different individuals with different assets – and therefore different needs – start spending their pension pots.
But as with all things, the devil will be in the detail and there is still a lot of work to be done in considering what default pathways and products might look like before we see them being a key part of the landscape.
Chris Curry is director of the Pensions Policy Institute
