Pensions – where next?
I worried that I might be a lone voice in my concern about the pensions changes announced in the budget, but if anything criticism has grown in recent days. I have also realised that I share a common agenda with at least some of those who have been cheering the Chancellor for ending compulsory annuities – they think it is a step towards a better system, while I worry that in practice it makes it harder.
So let’s work through the two arguments in favour of what the Chancellor is doing.
The government’s main argument is that this is an advance for choice and individual liberty – “Thatcherite” as Boris Johnson puts it. This is good, he says, even if it results in:
some foolish old people who end up living in a rusting and motionless Lamborghini and eating tins of dog food, because they have gone for the luxury car without making adequate provision for the rest of their needs.
This is undoubtedly attractive rhetoric – and Conservative strategists clearly think that this is a new symbolic policy that recaptures the vote producing power of council house sales. Skeptics, like me, are accused of not trusting people to make decisions about their own money.
But Mrs Thatcher was not good for pensions. You might expect that from a TUC author, but have a look at a pamphlet from right-wing – Thatcherite even – think tank Civitas or this from one of its authors.
The explanation (for poor pensions) is partly government policy, partly the way that the finance industry has behaved, and partly our own inability to work out what’s in our best interests. The Thatcher government, in its most radical, free-market phase, decided that pension provision would improve if individuals were free to opt out of company schemes and make their own decisions on how to invest their savings.
Deregulation had produced spectacular improvements in airlines and the telecoms industry – but pensions turned out to be different. Most of us are very bad at making decisions whose effects won’t be evident for a decade or more. We tend to take a wildly over-optimistic view of how likely our investments are to produce above-average returns – and most of us don’t do the sums to work out what we’re actually likely to get.
Not everything is best left to individual choice and provision. This is why we have a national health service which pools the risk of having to pay for expensive health care. We do not expect everyone to have a savings pot big enough to cope with any medical condition, just as we do not want an individualised pensions system that expects everyone to have enough pensions savings to last until they are 100.
It is also why we introduced automatic enrolment and expect good default choices in pensions. We left pension saving to individual choice and responsibility – and found that people stopped saving. Two in three private sector workers did not contribute to a pension before auto-enrolment kicked in. Everyone who supports auto-enrolment can be said to be saying that they do not trust people to behave responsibly – even if I would rather call it “a legitimate public policy intervention to remedy the cognitive bias that makes it hard for any of us to correctly make choices that involve deferring consumption to the future” – I can’t help the way I talk sometimes.
And individualising pensions in this way moves away from pensions as post retirement income. As the Civitas authors say “We think, as does almost every ordinary user of English, that a pension is a regular income.”
What is now clear is that there will be many unintended consequences from this transformation of pensions from primarily a retirement income arrangement to a cash pot. Chris Huhne is good on the housing impacts . Emran Mian asks some good questions about the impact on investment. The industry points out that annuitisation is already optional for many, but in practice does not work like that.
And even government supporters are working out that treating pensions pots as cash will mean anyone with any pensions savings will be likely to fail the test for any means tested help with social care. Others are worried by the potential for new mis-selling scandals a a point made in this very good piece by John McTernan.
The biggest question raised by this individualisation of pensions is why should they attract tax relief in the form that they do. At present you get tax relief at your marginal rate – or to put it more simply it costs standard rate tax payers 80p to save a pound in their pension, higher rate tax payers (disclosure: including me) 60p and top rate tax payers just 55p. While there is an upper limit of £50,000 a year for how much you can put in a pension and enjoy tax relief, this is massively skewed towards the better off. The Pensions Policy Institute, in work partially funded by the TUC, looked at who gains from the £23 billion of tax relief:
while basic rate taxpayers are estimated to make 50% of the total pension contributions, they would benefit from only 30% of pension tax relief. In contrast, 50% pension tax relief goes to higher rate taxpayers and 20% goes to additional rate taxpayers, while these groups make 40% and 10% of the total contributions respectively.
The argument for tax relief for pensions is that it is a legitimate public policy objective to encourage people to save for retirement as this will mean that they will not need to call on the state. But this rationale has now been parked in Britain’s Lamborghini dealers’ forecourts.
So even those who favour the principle behind the Chancellor’s announcement are going to have to face up to the unintended consequences.
But there is also a strong strand of support for the Budget proposals from people who think that annuities are so broken that anything that ends compulsion is good news. This is a powerful argument – perhaps best made by Henry Tapper with whom I am usually more in agreement than not. They are right to say that annuities are poor value, that they have been mis-sold and that they are structurally flawed. Henry was also good enough to publish this excellent critique by Hilary Salt, which I link t0 in order to draw attention to Alan Higham’s estimate in the comments that annuity mis-selling probably reduce post retirement income by 15 per cent. Even the editor of trade paper FT Adviser says that this is a:
a sector that has grown fat and lazy on the back of a product whose rising profitability is correlated to the decreasing value offered to hard-pressed savers.
Henry and I agree that collective DC is a superior pensions model than conventional DC. The current model of DC individualises the savings stage as members build up their own savings pot. But by compelling annuity purchase it shares the longevity risk – everyone gets guaranteed income until they die so need not fear running out of pension before death – and gets rid of investment risk by providing guarantees (or rather it crystallises it when the annuity is bought as annuity rates vary with investment conditions – the impact of sustained low interest rates and QE is why they are so low.)
Collective DC shares and pools risk during both the saving and spending stage of a pension. Returns are smoothed between members during the investment stage to reduce volatility, while in conventional DC assets are moved into low-return low-risk assets as you approach retirement to achieve the same end.
Decumulation – or turning your pension pot into pension income – can work in different ways in CDC. But CDC not only shares the longevity risk but substitutes a target for income for the guarantee provided by conventional annuities. This again is achieved by sharing investment risk and smoothing returns between members. This allows investment in higher return but more volatile investments that are likely in the long run to provide significantly better income than a conventional annuity, even they they cannot guarantee an increase every year (although of course most annuities bought in the UK are flat rate with no indexation anyway). The RSA suggest that Dutch pensions provide 50 per cent better pensions because they have an efficient CDC scheme.
The Budget proposals go in entirely the opposite direction to CDC however. They individualise the decumulation phase as well as the accumulation stage. Nothing has to be shared. Nothing is collective. There is no risk sharing or risk pooling.
This is why I think those that see the budget as a step towards CDC are wrong. For sure, one or two CDC schemes may be set up if the government changes the law as it has promised, but it is hard to see deregulation as a route to a mass roll out of the spread of collectivism. The Chancellor has probably destroyed annuities, but he has not put anything in their place.
But while I think the route ahead is now harder, I suspect that there will be many who disagree with that assessment who still want to go in the same direction as I would. (Hopi’s summary of IMF advice for Australia is relevant here .)
The most important points are:
- Most people will still want a pension primarily to provide income (and even if they don’t, it is still their best option – I don’t mind being paternalist when it comes to pensions, that’s why I back auto-enrolment.) This should be some kind of default inertia driven option.
- Sharing and pooling risk is the most economically efficient way to run decumulation (although individual annuities can still be an option – particularly perhaps for those eligible for impaired annuities.)
- The existing annuity market has failed as competition does not work in financial markets – the interests of providers and purchasers are not aligned. Public policy therefore has to drive alternatives run in the interest of members. NEST was set up to remedy market failure and drive standards up in the accumulation stage. Something similar will be needed for decumulation.
- While there need to be defaults, there needs to be more choice about how income is taken as more people are likely to make a flexible transition to retirement.
And if we can do this in ways that increases investment in infrastructure such as new housing – exactly the kind of long term steady investment that suits pensions – rather than inflates the house price bubble, all the better.
My big hope is that this is where a new progressive coalition can be built from all of those who recognise that pensions are not really pensions unless they provide income and involve some sharing of risk, whatever their initial reaction to what the Chancellor said.
And probably we need a name other than collective. Otherwise Boris won’t like it.
To finish I’m sure our friends at Ripped Off Britons won’t mind me borrowing their cartoon.