July pensions supplement: an unfinished revolution

Read the rest of our July pensions supplement

If, a couple of years ago, you had found yourself standing next to someone at a party who said they were a pension advisor, you would probably have been less than overjoyed. A brief exchange of stilted pleasantries is about the best outcome either of you could have expected. Things would be rather different if you bumped into the same advisor again this summer: rarely have so many people spent as much time talking about one of the most complex and important financial issues that any of us will face—how to pay our way in the world once we retire.

An asteroid has struck Planet Pension. Until the Budget in March 2014, the rules that govern pension saving had developed by a process of sedimentation: year after year governments and regulators deposited layer upon layer of minor changes and tweaks on top of the last, creating a complex landscape that very few people could navigate with any confidence. Then came a bolt from the blue. Suddenly, the longstanding obligation on all but the wealthiest retirees to turn their pension fund into a guaranteed income for life via an annuity was scrapped. Instead, we were promised freedom, choice and flexibility.

This new world sounds appealing. We are now allowed to access the money we have saved once we reach 55. Provided we are prepared to pay the requisite income tax, we can take all the cash out in one go; we can leave it invested and start drawing an income from it; we can leave it where it is and carry on working or live off other assets; we can bequeath anything that’s left to others when we die without punitive tax charges. At last the shackles are off.

However, in these early days of pension freedom much remains unclear and unresolved, and all we can say with any confidence is that we know what people don’t want to do. Top of this list is to buy an annuity. As widely predicted, sales of these insurance policies that provide a guaranteed income for life have plummeted, falling by 50 per cent since the 2014 Budget as people waited for the new rules to take effect in April. When that moment arrived, other things that people did not want to do also became clear. According to the retirement income specialist My Pension Expert, only 1 per cent of people in its research have chosen to strip out an entire fund in one go since this became an option, and those funds that were emptied were mostly very small. This finding is broadly supported by information from Scottish Widows, which says about half the customers contacting it to discuss ways to access their pension fund are looking to withdraw the entire pot and that 85 per cent of funds currently being cashed in are worth less than £30,000. Once people realise the tax hit they face if they cash out a large fund in one go, they tend to leave most of the money where it is and look for other options.

The problem so far is that although they have freedom in name, in practice there are very few ways to exercise it.

The major new product that many expect to emerge is “low-cost, flexi-access drawdown”, effectively a way of leaving your pension fund invested in the financial markets so that it can continue to grow, while at the same time allowing you to take an income from it that is flexible rather than fixed, meaning that you can dip into the fund for one-off needs as well as varying the amount you take out as regular income. It sounds great but to date most drawdown products remain “hideously expensive,” according to Henry Tapper of First Actuarial, the pensions consultancy, with fees eating up most if not all of the likely income from the pension pot. “I’ve seen examples of charges of more than 4 per cent a year on yields of 5 per cent,” he said. With annuities still looking to most people like poor value and cash withdrawals triggering large potential tax liabilities, genuine room for manoeuvre remains pretty limited. “Whichever way you look at it, if you’re trying to exercise your freedoms at the moment it’s extremely hard to get value for money,” he said.

Issues such as charges, tax and value for money are far from the only hurdles that confront people who are trying to take control of their savings. Since the changes came into effect, there has been a marked increase in the number of people seeking to transfer funds they have built up in final salary occupational pension schemes into defined contribution schemes, so that they can access the money when they want to rather than receiving a guaranteed monthly income for life linked to the amount they earned. Tapper said his firm is seeing three or four times the usual level of transfer inquiries from people trying to leave final salary schemes.

This trend worries many people involved in the pensions industry. Opting to give up a guaranteed, inflation-linked income that will last until you die (and that may continue to provide an income to a surviving spouse or other relative) looks, on the face of it, a deeply irrational choice for most people. It could make sense if, for example, your life expectancy has been severely reduced and you want the bulk of your money to go to your heirs rather than disappearing back into the fund’s coffers when you die. But advisors agree that in most circumstances people are better off staying put.

And that, in practice, is what they are doing—not because they want to but because they have no choice. The potential downsides for most people of leaving a final salary scheme are so significant that in an industry with a long history of mis-selling scandals no one is keen to set themselves up for another one further down the line. As a result, anyone who wants to transfer out a final salary pension pot worth more than £30,000 has to take independent financial advice, while the companies to which they want to transfer the fund are not allowed to accept it without written evidence from an advisor that they have recommended the switch. This effectively transfers any future liability to the advisor if things go wrong.

Financial advisors, meanwhile, are telling almost everyone who approaches them not to withdraw. “It’s very hard to recommend leaving a final salary scheme: you need some pretty extreme circumstances,” said Robin Keyte, a leading financial planner based in the West Country. Industry observers say that advisors’ nervousness about making these recommendations is being compounded by professional indemnity insurers who are refusing to cover these cases, leaving the advisor with unlimited personal liability should trouble emerge later on. So once again, people have heard the message that they are now free but are hitting barriers in almost every direction.

In cases such as final salary scheme withdrawals, you could argue that is no bad thing. This instance provides a particularly vivid example of one of the dangerous side-effects that experts point to in the reforms: the pervasive allure of cash in the hand. “My big worry with this new legislation is that it focuses people on jam today and that they’re losing sight of what they’re going to need when they’re in their late eighties and early nineties,” said Keyte. The so-called “time value of money” is a basic economic principle reflected in a widely observed behavioural bias: most people ascribe a higher value to cash now than to a promise of the same amount of cash at some future date. The recent increase in the number of people trying to give up guaranteed future income for cash today suggests this bias is exerting a major influence. So far, disincentives such as reluctance among advisors to endorse their plans or the prospect of large tax bills if they strip out their pension funds have been enough to head off most of the worst-case scenarios that pension experts have feared.

Similarly, Keyte believes that the promised right for people who have bought annuities to sell them for a cash lump sum is unlikely to be delivered in practice and even if it were, would offer good value to a very small proportion of exceptional cases. “My gut feeling is that it just won’t happen,” he said. The costs involved in the process are likely to be so high that the returns sellers would see could be extremely low. “If you had an initial purchase price of £100,000, how little of that would you get back? I could easily imagine it being just £20,000 or £25,000.”

In the new world of pensions, therefore, it appears that barriers exist to prevent people exercising “the wrong sort of freedom.” If they are to benefit from the right sort, however, some dull but important things need to get done. The fact that there is still a shortage of “products to match people’s expectations,” as Tapper put it, is due in large part to the mundane question of the IT systems upon which the United Kingdom’s pension providers currently depend.

In order to provide the sorts of flexible product that the new rules are leading people to expect, pension providers will need much better IT systems than most of them currently possess, said Chris Curry, Director of the Pensions Policy Institute. There are several issues. First, many rely on ageing technology that in some cases cannot provide all the information that people need in order to make informed choices about how to exercise their new freedoms. Second, many companies do not have systems that can deliver the flexible access that has been promised. In particular, those that have up to now been involved in the “accumulation” phase of pensions, during which people save into their fund, may well not have systems that can handle “decumulation,” during which the fund may remain invested while also paying out a regular income as well as one-off withdrawals. If these providers want to retain savers’ funds when they stop accumulating and instead start taking an income, they are going to need technology tools they do not currently have.

The business of administering thousands of individual pension accounts that can manage an investment portfolio as well as handling regular and ad hoc cash withdrawals of varying size, while taking into account the right to withdraw 25 per cent of the fund tax free and charging the correct rate of income tax on the remainder is highly complex, deeply unglamorous and crucially important. It is on foundations such as these that the reality of pension freedom will have to be built. There is a tricky balance to be struck, however. Without modern IT systems, ideas such as the “pension bank account” that have been much discussed will struggle to get off the drawing board, but if, as seems likely, caps on the fees providers can charge are introduced, some may argue that they will not be able to recoup the investment that will be needed to create the necessary technology systems.

This is an unfinished revolution. But in spite of that can we point to any successes when so many crucial elements appear still to be missing or barely visible? Arguably we can. Keyte said that the promise of greater freedom and flexibility in how we can manage our money, along with the move to make undrawn funds inheritable without steep tax charges, is making people he speaks to more willing to save for their retirement. This supports the notion that the previous regime had come to appear so restrictive and the returns available so unappetising that it had become a disincentive to save.

And beyond that, there is simply the beneficial effect of the government’s bolt from the blue—suddenly people are thinking and talking about pensions as almost never before. “I do think that all the debate and coverage has made people think more positively about pensions and that has to be a good thing in the long term,” said Curry. “If they can see pensions in a more positive light, they must be more likely to want to be part of the system than to avoid them or not to trust them.”

It could well be that the next time you spot that pension advisor at a party, you’ll have to elbow your way through a crowd to get to them.