In one swoop, Budget 2014 destroyed UK pension policy. The chancellor’s announcement that individuals will no longer have to buy annuities is possibly the most catastrophically bad policy decision made by this government. It will almost certainly have to be reversed, if it can be.
So let’s start at the beginning: what are annuities?
Annuities exist to help retirees navigate the central dilemma for them in managing their retirement income: how do you ensure you don’t run out of money in your old age before you die? This is ‘longevity risk’ – the risk that you will live longer than you expect, spend down your savings too early and live your final years in penury.
So, in return for a cash lump-sum premium – built up in a ‘defined-contribution’ pension scheme – an annuity will pay someone a regular income until their death, whether that is after five years or 50. Currently, about a third of workers reach retirement with this form of pension saving, although the prevalence is set to grow.
But, there’s a fundamental problem with annuities: most consumers just don’t like them. When faced with the voluntary option of pooling longevity risk, most people reject it. Usually, people can’t get their head around the idea that a lump-sum payment worth tens of thousands of pounds equates to a small weekly income, and that if they die after a few years, their relatives won’t get anything back.
As a result, the prevalence of voluntary annuitisation is extremely low, even though pooling longevity-risk is the perfectly rational thing to do for someone seeking to smooth their income across their life course (not experience a sudden drop in income upon retirement).
In fact, there is an entire academic literature on the ‘annuity puzzle’, ie why do individuals not voluntarily annuitise their savings? If you don’t believe me, head over to Google Scholar, and enter 'annuity puzzle'.
In recognition of the annuity puzzle, UK private pension policy has for years had at its core the so-called ‘annuitisation deal’: pension saving benefits from exceptionally generous tax-relief and – following implementation of the Turner Commission reforms – guaranteed employer pension contributions. But, in return, pension savers have to accept conditions on how they use their pension savings; specifically, they have to convert these savings into a secure retirement income that pools longevity risk.
For defined-contribution pension savings, this has meant purchasing an annuity (or more recently, adhering to strict rules on ‘flexible drawdown’).
In this regard, the annuitisation deal is explicitly paternalistic: it ties people into doing what they otherwise might not want to, recognising that people make poor financial decisions, and are not perfectly rational. In recent years, we have come to call this sort of thinking ‘behavioural economics’.
On Wednesday, the chancellor tore up the ‘annuitisation deal’, saying: “People who have worked hard and saved hard all their lives, and done the right thing, should be trusted with their own finances.”
So, in future, no one will be compelled to buy an annuity with the pension savings. Only the incidence of their marginal tax-rate will be a disincentive from taking the money as cash, although given total flexibility of drawdown, few will be likely to pay more than basic rate income tax on pension savings.
The problem with the chancellor’s decision is very simple: all the evidence indicates very few people will opt to buy an annuity under the new rules – and the assumption of 30% taking this route deployed by the Treasury in its costings appears highly optimistic. Instead, most are likely to take the cash and then – unsure how much they can spend down – will simply sit on it or invest it elsewhere (more of which below).
In other words, they will freeze in the face of longevity risk, as research on the annuity puzzle has long highlighted. A small but significant minority will, of course, spend all the money, and then find themselves in penury.
Ultimately, the chancellor’s decision to scrap the annuisation deal and rules on compulsory annuitisation is catastrophic.
First, given most retirees will opt not to annuitise, the evidence suggests they will sit on their savings with a depressed retirement income, or run out of money altogether. This is not only inefficient in economic terms, it will also lead to pretty miserable circumstances for millions of people. It replaces the security and peace of mind of an annuity with insecurity and fear (and incidentally, far more older people being targeted by unscrupulous family members or fraudsters).
Second, the chancellor has in one stroke released the £12bn of savings annually spent on annuities for retirees to transfer elsewhere.
Now consider the following scenario: as you reach retirement with a pension pot of – say - £65,000, you have an annuity explained to you, but really don’t like the idea of handing over all this money, only to see nothing given back if you die early.
Instead, you think: where could I put my £65,000 that would provide a steady predictable income, hopefully grow the value of my £65,000 pot, and also leave something behind for my family?
What are you going to do? Yes, that’s right: you’re going to put the money into property and buy-to-let.
Indeed, one outcome that Treasury advisers may have not anticipated is that they are releasing literally billions of pounds of savings that some baby-boomers will inevitably now transfer into the UK’s overheated property market. The annuity market is already worth £12bn per year, but if some workers aged 55 also decide to opt-out of pension saving early and sink their pension savings into property, the potential effect on house prices could be even greater.
As such, it is highly likely the chancellor’s annuity announcement will also turn out to be disastrous for first-time buyers, and could represent the death-knell of aspirations of home-ownership for millions of young families. In today’s overheated property market, the chancellor has effectively decided to air-drop an enormous tanker of rocket-fuel.
So what is behind the chancellor’s decision? Scrapping compulsory annuitisation is aligned with traditional Conservative notions of personal responsibility. The Treasury may also have their sights set on an early tax windfall as retirees opt to just take their pension cash and pay tax on it.
Annuities have also had a very bad press recently. There’s been growing criticism of poor value annuity purchases through lack of shopping-around. The incomes paid by annuities – ‘annuity rates’ – have also come under enormous pressure due to economic trends (low growth, low interest rates), government policy (quantitative easing) and demographic trends (increasing life expectancy).
A better response to these issues would have been mandated advice upon purchasing an annuity (and, in fact, the chancellor also announced a guarantee that all annuitants will in future be offered free and impartial face-to-face guidance on their choices at the point of retirement). And some academics have long argued annuity rates could be improved if the Treasury would underwrite some longevity-risk for insurers through ‘longevity bonds’.
Instead, Treasury special advisers have opted to pull the plug on annuities completely (and it is hard to imagine the Department for Work & Pensions is really so comfortable with this decision). Unfortunately, once gone, it will be very difficult to resurrect the annuitisation deal, even as successive governments have to deal with the consequences.
The remarkable thing is that through the implementation of the auto-enrolment reforms, and the Single-Tier state pension, this government could have reasonably declared itself to have had the most successful pension policy of any government in decades.
Instead, the chancellor has effectively scrapped private pension policy: the workplace pension schemes that employees are now being auto-enrolled into will effectively become just another tax-incentivised savings scheme with a bit of age-conditionality applied to when you can get your hands on the money.
Millions of pensioners will suffer lower retirement incomes as a consequence of the chancellor’s decision, and the unforeseen consequences could be disastrous for priced out first-time buyers if enough baby-boomers plough their pension savings into property. In short, a policy catastrophe.
