Workforce & Economics

UK pension freedoms – the unfinished business

May 3, 2016
By Steve Webb

Last year’s changes to the UK ‘at retirement’ market were the most fundamental in a century. While savers with small pension pots had long had the option of taking their savings as cash, and large savers could turn their pots into sophisticated ‘drawdown’ investment products, the mass market previously had little choice at retirement but to buy an income for life.

The April 2015 reforms changed all of that. Suddenly, those aged 55 or over with Defined Contribution (DC) pension pots had a vast array of choices. They could take the whole pot as cash, could take a tax-free lump sum of 25% and leave the rest invested, could take a mix of taxed and untaxed cash, could buy an annuity or could invest in a drawdown product with no restrictions on the rate of withdrawal. So as we approach the first anniversary of those changes, how well have the reforms worked and what are the outstanding issues which need to be addressed?

As we approach the first anniversary of the UK’s pension changes, how well have the reforms worked and what are the outstanding issues which need to be addressed?

There is no doubt that the announcement of the changes in March 2014 was hugely popular, generating glowing front-page newspaper headlines. For many years the reputation of annuities had been suffering. Annuity rates were low and falling, not least because of the low interest rate environment and improvements in longevity. But the annuity market itself was seen to be failing, with too few people shopping around for the best annuity deal, and too few people benefiting from individually underwritten annuities which took account of their individual health and life expectancy. Furthermore, there was a danger that the millions of people being automatically enrolled into workplace pensions would be discouraged from saving because the destination would in most cases be an annuity which was perceived to be ‘poor value’.

It is debatable if annuities were actually poor value, and certainly longevity insurance is an important part of retirement provision. However, the widespread perception of poor value, particularly in the media, coupled with the market failures outlined above, meant that there was great appetite for reform. Whilst in principle anyone could go on investing their pension pot for years into retirement and enjoy an income through ‘drawdown’ products rather than using the whole pot to buy an annuity, in practice such products were generally the preserve of the better-off and most engaged, and even in these products withdrawals were tightly restricted.

Statistics from the Financial Conduct Authority (FCA) show that, in the first two quarters after the reforms were implemented, around 380,000 pension pots were accessed. Because the change was pre-announced by just over a year, there was a wall of pent-up demand when the new options went live on 6 April 2015, and it is probably too soon to see what the ‘business as usual’ pattern of behaviour is likely to be. But the quarterly figures for July-September 2015, published in January 2016 provide some broad indications of how the market is likely to develop.

Of the 179,000 pension pots accessed in that period, roughly two thirds were taken wholly as cash. Whilst this may seem shocking to those concerned about income and well-being through retirement, it is worth noting that 8 out of 9 of these pots were classified by the FCA as ‘small pots’, namely those under £30,000.

From Royal London’s experience, we know that in many cases these will not be the only retirement assets of the individual in question. The individual may be part of a couple in which the other partner has pension wealth. They may have their own state pension rights, and/or salary-related pension rights and one or more other DC pensions. So just because someone cashes in a relatively modest pension pot, it does not mean that they will be destitute in later life.

Sales of annuities unsurprisingly slumped following the announcement of the new freedoms, but the most recent data from the FCA suggests that sales have stabilised, if not slightly recovered, though data inconsistencies mean it is too early yet to discern a clear trend.

The FCA statistics also show that the take-up of regulated financial advice varies considerably. 58% of those who invested in a drawdown product (typically those with large pots) took financial advice before doing so, but only 37% of those who bought an annuity paid for financial advice. Appointments with the Government’s free PensionWise guidance service were taken up by only around 17% of those who released their pension pot in Q2, which is obviously a relatively low figure. However, the Government would point out that much of the information supplied as part of the free guidance service is available on the PensionWise website, which has experienced more than two million hits since first established. In addition, many of those with the smallest pots may have been clear what they wanted to do and not felt the need for further advice or guidance.

So what do these figures tell us about the early success of the policy and what are the outstanding issues that need to be addressed?

The first key issue is the advice and guidance framework. In general, individuals ought to be in a better place to assess what they want to do with their own money than the state, especially given the diversity of individual household circumstances and priorities. It is unlikely that one-size-fits-all mandatory annuitisation is likely to be the best outcome for many.

But, of course, there is a risk that individuals may make poor choices, whether through lack of understanding of complex financial products, or because of behavioural biases such as under-estimating how long they are likely to live.

This is why the advice and guidance framework is crucial and few would argue that we have yet reached a satisfactory position. It is generally understood that whilst better-off individuals with larger pension pots are more likely to pay for advice, and those with the smallest pots are unlikely to suffer serious detriment from an unadvised decision to cash in their pot, there remains a significant ‘advice gap’ in the mid-market. These are the individuals who have pots that are large enough for them to consider something other than cash or an annuity, but who may be put off by the perceived cost of financial advice.

It is in this context that the UK Government has launched its Financial Advice Market Review (FAMR) designed to look at ways of filling this advice gap. The conclusions of this review are expected in the March 2016 Budget and a wide range of ideas are under consideration to improve access to and take-up of advice and guidance, especially in this crucial ‘at-retirement’ space. Clearly, a preferable situation would be one in which individuals are financially capable and engage with their finances through their life, but this is very much a long-term goal. Policy-makers will have to ensure that those who have reached retirement with relatively little financial knowledge or capability have the tools that they need to make good choices.

A second, and related, area where more needs to be done is the position of vulnerable customers. These could include the oldest pensioners, those with dementia and other cognitive impairment, and also those at risk of being exploited by scams. To the extent that the reforms address capable, well-advised people in their mid-50s making decisions about their finances, then there is every reason to think that the new freedoms will enable those people to achieve better outcomes. But without any default annuitisation, in principle, policy-makers are expecting people to go on making sophisticated financial decisions right through their retirement. Given the general cognitive decline associated with later life, to say nothing of the growing incidence of dementia and other conditions, more thought needs to be given to support for such individuals. Whilst the re-introduction of default annuitisation at a later age (e.g., 75 or 80) would fly in the face of the spirit of the new reforms and would be politically infeasible just months into the new system, much more attention will need to be given to ensuring that we all continue to get the best outcomes not just in early retirement but throughout our lives.

A related group of vulnerable (or occasionally gullible) individuals who need to be protected are those at risk of scams. In the past in the UK, a lot of the activity of scammers was focused on persuading those with large pension pots to ‘liberate’ them at an early age by putting them in an attractive-sounding alternative investment. Whilst not technically illegal, such liberation generally attracted a large tax penalty, and many people found that their money was also subjected to high and arbitrary charges and in some cases disappeared altogether.

Whilst this form of Pension Liberation Fraud has not stopped, the scammers are now turning their attention to those over 55 who have much easier access to their cash. Partly because of the current low interest rate environment, there is considerable appetite for alternative investments which appear to offer especially attractive returns. Given the freedoms which consumers now have about using their pension funds, it can be increasingly difficult for pension providers and pension plans to block transfers, even in cases where they suspect the consumer will get a poor outcome. Regulating to protect vulnerable consumers against scams in a world of pension freedoms is another area where more work needs to be done, as early statistical evidence suggests that such activity has shown a marked increase since April 2015.

A final area where much more work is needed is in the space of product innovation. Not entirely surprisingly, the period from the announcement of the new policy in March 2014 to implementation in April 2015 was very heavily focused on making sure that the new freedoms could be delivered on time. New legislation had to be drafted, consulted on, and implemented, and pension providers needed to spend millions ensuring that their computer systems and new staff were able to deal with the expected torrent of inquiries, especially at the start of the new freedoms.

It is not surprising that, against this background, product providers initially devoted relatively little attention to developing completely new products to take advantage of the new freedoms.

But there are early signs that more product innovation is starting to take place. One of the dangers of the reforms was that the valuable longevity insurance provided by an annuity would be dispensed with altogether. There is now the risk that people might either consume their retirement wealth too quickly, leaving themselves in need later in life, or consume it too cautiously, having too low a standard of living in retirement for fear of running out.

A key area for product design will be to build in some element of longevity protection without replicating the problems of the old annuity market. There is also much more scope for innovation when it comes to insuring against the potentially catastrophic costs of needing long-term residential care late in life. This has remained a relatively untapped area, but the new freedoms offer the potential for integrated pension and care insurance products to be developed.

It was clearly not practical for the pension freedoms to wait for all of these issues to be ironed out up front. In the case of product innovation, for example, it is inevitable that commercial providers will only get serious about innovation when there is a market out there to win. So far, the freedoms have allowed hundreds of thousands of people to access their hard-earned cash in a more flexible way, and this must be a good thing for most. But further action is needed on advice, on protection for the vulnerable and on new products if the reforms are to be viewed by history as an unquestioned success.

How have pension freedoms affected the industry?

After reading Steve Webb’s policy perspective, watch BlackRock’s Tony Stenning explain how pension freedoms has affected the industry.

Author: Steve Webb

About the author

Steve Webb
Director of Policy, Royal London Group

Steve Webb is Director of Policy at Royal London Group. Between 2010 and 2015 he was Minister for Pensions in the UK Coalition Government which implemented the Pension Freedoms.