Automatic enrolment into workplace pensions will see the vast majority of people enrolled into risky ‘defined contribution’ schemes in the future. They probably don’t realise it yet, but this means they need to annuitise their pension pot when they get to retirement, in order to turn their savings into a regular income, guaranteed for life.
The problem is that annuity rates are particularly low at the moment, undermining the value of pensions saving. The market for annuities has always been fairly opaque, plagued by huge information asymmetries between consumers and providers, chiefly insurance companies (and remember that auto-enrolment is based on the notion that consumers should be able to remain disengaged yet still receive good outcomes from saving).
So the news that the Financial Services Authority (FSA) is to review the annuities market is very much welcome. But will their review go far enough to address problems in the marketplace? The initial signs are not encouraging.
I believe that low annuity rates are quintessentially a product of a flawed market structure not operating in the best interests of consumers. There are of course other explanations – none of which the FSA has much power to address. Quantitative easing has depressed annuity rates by depressing gilt yields. Worryingly, new EU rules on insurance company funding will almost certainly require insurers to invest more in gilts, which would reduce rates even further. Insurers will rightly argue that ever-increasing longevity is also one of the drivers for historically low rates. But pricing based on average or typical life expectancy means people from poorer backgrounds, who tend not to live as long, lose out.
The FSA’s inquiry appear to be based on one aspect of the annuities market; that is, the extent to which people are able to ‘shop around’ to get the best annuity deal when they reach retirement. Most consumers choose an annuity from the same company that provides their pensions saving product. The first phase of the review will ask about the extent to which customers lose out from not shopping around, and the second phase (by which time the FSA will have morphed into the Financial Conduct Authority) will ask whether the ways in which providers communicate with consumers tends to inhibit shopping around.
Shopping around is a vital issue – it can lead to savers getting a much better deal. But it is probably not the most important problem within the annuities market. Insurers have in fact already demonstrated significant progress in promoting shopping around to their customers before they reach retirement. This is good news, but makes it even more perplexing that the FSA has decided to focus only on this narrow issue.
As annuities expert Ros Altmann argues, the review ‘needs to look past the obvious problems’ in the annuities market. People should be encouraged to choose the right product, not simply get the best rate for the wrong product. For instance, many people in ill-health would benefit from enhanced annuities, designed for people with low life expectancy – it seems unlikely the review will consider whether they are well-served by the market.
The review also seems to be overlooking the cost and availability of financial advice. In the current marketplace, advice is often required to get the best deal – but it is prohibitively expensive for those with small pension pots. Of course, the review could go even further by considering how to automate the decumulation process (now that the accumulation phase is now largely automated). No matter what the FSA recommends about shopping around, inherent complexity means it will only ever be the preserve of the financially savvy – and I am certain that shopping around rates will fall even further as auto-enrolees start to reach retirement.
A further limitation of the review is that it is focused only on people in contract-based pension schemes. These schemes fall under the FSA’s remit, while trust-based schemes are under the Pensions Regulator’s (TPR’s) remit. This is extremely unfortunate given that even trust-based scheme members have to buy an annuity when they reach retirement; their trustees are only responsible for the accumulation phase.
This peculiar situation means that the review will fail to learn from best practice in the trust-based world. NEST, for instance, has established a panel of annuity providers that should enable members to get good annuity deals – perhaps even better than those available on the open market – without needing to undertake the perilous shopping around journey. It also means the review will fail to address potential problems arising from annuity providers establishing trust-based schemes (so-called ‘master trusts’). Members of these schemes may appear to be shopping around even if, ultimately, their pension product and their annuity are provided by the same parent company.
Auto-enrolment will be a huge step forward in terms of rectifying problems in the accumulation phase of pensions saving – although there is much more work to be done. Yet we have barely scratched the surface of addressing problems in the DC decumulation phase. The FSA has an opportunity to put this right, but the review as it stands is too narrowly defined to inspire confidence among consumers.