A pensions disaster in the making?
I am more and more concerned about the budget changes to pensions. My initial reaction was one of worry – now I am both alarmed and angry.
The policy proposals are worrying because they take pensions policy in entirely the wrong direction – back to the 1980s. The policy process rips up a painfully constructed consensus. The combination of the two could be very bad news for pensions.
We have spent more than a decade trying to modernise UK pensions though consultation and consensus building. The Pensions Commission set the road-map in its report of 2004. Since then we have introduced auto-enrolment, set up NEST, reformed the state pension (more than once) and despite some sharp arguments along the way have ended up with a system with wide support, if insufficiently generous.
That journey is far from over. There is general agreement that contributions are too low, that annuities are not working and that we can both make DC pensions better value for consumers and think hard about new “defined ambition” structures that can provide better pension outcomes for members.
Yet on Wednesday the Chancellor tossed this process aside and announced major changes with no consultation or engagement with any of those involved in the pensions debate. I am not naive enough to object to politicians being political, but given how successfully pensions policy has evolved over the last ten years, this was vandalism.
That is why I am angry. Now why am I alarmed?
My basic problem is that the Chancellor is redefining pensions as just another savings scheme. Mr Osborne sees pensions as just another tax privileged ISA style savings product. With ISAs you save after tax, but do not pay tax on what you take from them. With pensions, it is the other way round. You get tax relief on what you pay in, but pay tax on what you get out. ISA contributions are limited. Arguments against the huge spending on tax relief for pensions may now also grow.
But most people think of pensions as regular income in retirement. Of course many will take a lump sum as they retire, and it makes sense to let people with savings too low to provide a decent top up to the state pension to take all their pot as cash. But the ideal remains a regular income paid from retirement until you die.
Steve Webb was honest to say that people will be able to splurge their pension on a Lamborghini if they wish and that the state would take no view of that. Indeed the government is tacitly hoping this will happen. The Treasury is expecting a nice extra tax nest egg as people take their whole pension and pay tax on it in the next few years. As others have said, this will also be likely to increase the buy-to-let market and put pressure on house prices.
But while some will splash out, most people are more likely to do the opposite. They will not know what to do with possibly the biggest sum of money they have ever had, and will end up being overly cautious – putting it in fixed interest account that will not keep up with inflation – and never quite knowing how to spend it. No-one can know how long they will live. However much financial advice and education people get that remains unknowable.
Ministers have been talking about spreading choice and personal responsibility. Thais was exactly the language used in the 1980s when government celebrated personal pensions and allowed opt-outs from SERPS. It sound great, but led to the collapse of workplace saving with fully two in three private sector workers failing to contribute to a pension by the start of auto-enrolment. The whole of the Pensions Commission Report was based on a rejection of this approach. It instead started with defaults, simplicity and inertia. Behavioural economics should have taught us all by now that people are very bad at exercising choice and responsibility in pensions.
Not only should pensions be about post-retirement income, they have also in the past always had an element of risk sharing and pooling. DC pensions have ended that during the savings (accumulation) phase, but annuitisation still shares risk during the spending (decumulation) phase. Osborne pensions however become entirely individualistic. You save up when you work and you spend when you retire.
This is economically inefficient. The insurance principle shares risk. If you do not insure your car, you always need to have the full price of replacing it available and be able to meet any legal claims against you if you have an accident.
Annuities similarly share risk. No-one can know how long they will live. If you need to cope with that as an individual you need to assume that you will live a very long time and build a huge pot. Annuities can be thought of as buying insurance against living longer than you expect (even if that is a much better prospect than crashing your car).
That is not to say that our current annuity system works well. It does not, but we should replace it with a system that still shares risk.
There are a number of problems with our annuity system. Firstly there are too many rip-offs. The market does not function well and people fail to shop around to get the best deal they can.
Secondly one result of the economic crash and QE is that annuities are very expensive, because interest rates are so low.
This is connected with the third issue. Annuities usually provide a guaranteed income for the rest of your life. Guarantees however are very expensive. Looking after your pot in a way that guarantee you will get your promised income for what could be decades in the future requires very conservative investment strategies.
But if there is no guarantee, funds can be invested in ways that are likely to provide bigger returns on average. If you then share (rare) losses with gains you may not be able to guarantee an income but you can expect to do better most of the time. This is the advantage of collective DC.
Lastly it is also true that people underestimate how long they are likely to live. If you think you have only ten years to live, annuity rates for a more realistic twenty pear life span will always look mean. This is undoubtedly a big part of the general hostility to annuities.
So what should we do? A much better direction of travel – and one that Steve Webb appeared to be on before the budget – would be to move towards more risk sharing and risk pooling in collective DC pensions that combine the saving and spending stages.
But can we do something to reinvent the annuity too? There have been suggestions that the financial services sector will innovate and develop new products. Unfortunately too often in the past that has led to first a mis-selling scandal and then a crackdown.
Markets simply do not work in financial services and if we are going to innovate here, it would be better to design new publicly sponsored arrangements – as we did with NEST for the accumulation stage. They need to be simple and straightforward, not drowned in complexity that can only confuse.
The objective would be to develop a decumulation mechanism that shared longevity risk, but did not guarantee payments as with CDC. It would need people with actuarial skills to think this through, but I see no objection in principle to such a mechanism.