By Saq Hussain, pensions director, PwC
The Chancellor's budget reforms back in March, ushered in a new era for defined contribution (DC) pension savers.
Suddenly, pensions have become attractive and flexible tax efficient savings vehicles freed from their previous shackles. We are finally to be trusted with managing our own savings – with a little guidance from the government along the way. The reforms are certainly popular. Our research shows that given the choice, over three quarters of people retiring with a DC pension will not buy an annuity, preferring to manage their own money.
But I can’t help thinking that engaging people to really understand the risks they face in retirement will be an uphill task. Will we still be as enthusiastic in 20 years’ time about these changes, or will we be repenting at leisure?
The Australian experience suggests that we may be repenting. In Australia, half of all retirees take their pension as a lump sum and a quarter deplete their pension savings by age 70. The tax and pension environment is very different from our own, but an Australian Government inquiry has become concerned enough to consider some form of compulsory annuitisation. The recent Murray review concluded that the retirement phase of Australia’s superannuation market is ‘underdeveloped' and ‘does not meet the risk management needs of many retirees'. It also noted that the availability of a lump sum at retirement can encourage greater pre-retirement consumption and potentially debt.
Australia has a well-developed DC pension funds system, but OECD figures show that the Australian annuity market is one of the least developed in the world. Yet the same organisation lists two of the key characteristics for ensuring good DC outcomes as encouraging annuitisation as a protection against longevity risk and promoting the supply of annuities and cost-efficient competition in the annuity market.
Trusting people not to be feckless spendthrifts with their retirement savings is probably correct, but it still leaves individuals with the challenge of how quickly or slowly they should spend the money given that they will not know when they will die. An annuity remains the simplest way for an individual to hedge against outliving his or her retirement pot.
Most people know, and dislike, that with an annuity your capital is lost when you die. What is often less well understood is that the “lost” capital of those dying young is actually spread across the annuity pots of those annuitants who are still alive. As everybody gets older, the additional capital received every year by the pots of the still-living annuitants from the pots of fellow annuitants who die allows the annuity to continue to be paid to the ever dwindling band of survivors, even if the long-lived ones live to be over 100.
The amount of capital automatically redistributed in this way from those who die young to those living longer increases with age as the probability of dying increases. A person in income drawdown will not get this benefit and would need to earn extra investment returns to keep up. (On the other hand, in income drawdown the person still has their own retirement fund on death). The redistribution effect is relatively low at younger ages but soon climbs to become powerful in the 70s and above. It is this that makes drawdown a less efficient option for providing retirement income, but an efficient way to leave funds to your heirs if you intend to die young.
The aims of the new guidance regime are laudable, but there is no certainty people will engage. If they do, it is crucial that guidance helps people understand the risks of a long retirement and running out of money. The big question facing anyone retiring is ‘how long am I going to live?’ Helping people understand that the answer is both “unknown because it varies” and equally importantly that “it could be a very long time” will be key to ensuring retirement security for millions of people.
For more information please contact Saqib Hussain, email: email@example.com tel: 0161 245 2554