From the TUC

This is not a pensions strategy

19 Mar 2014, by in Pensions & Investment

There is a big shake-up of pensions in the budget, particularly for defined contribution or DC pensions, which are set to grow in importance as auto-enrolment spreads. (DC pensions build up an investment pot while people are working, which then have to be turned into pension income when people retire.)

Janet has already looked at the changes, but here are some further thoughts from me.

Many of the changes make sense as individual proposals. Many people are set to retire with small DC pots, particularly in the early years of auto-enrolment – and annuities (the insurance product that provide a regular income until you die in return for handing over your pension pot) provide poor value for small pots. It therefore makes sense to make it easier for them to take a lump sum rather than a tiny pension.

But there is a real question here. Has the Chancellor ended up undermining the basic principle that pensions should provide income on top of the state pension throughout retirement?

This is best illustrated by the proposal to allow people to take their entire pension pot as income from the age of 55 subject to paying at their marginal income tax rate. This does not look much like a pension, but will certainly be of interest to the tax planning industry. If people do this at present, they have to pay 55 per cent tax.

One of the worst bits of pension jargon is trivial commutation. This allows people to take small DC pots as lump sums rather than be forced to turn them into (tiny) annuities. The current upper limit for this is £18,000. It makes sense to increase this – and the new figure of £30,000 looks at first glance to be reasonable.

People with pots above the trivial commutation limit have either had to buy an annuity or use a drawdown mechanism. The budget liberalises this regime considerably, and it looks like annuities could well become a minority niche product in future.

With means testing levels set higher than the basic state pension, it made sense to ensure that people turned their pension into a steady income rather than use it all up early in their retirement and then claim benefits.

Presumably the government now thinks that with the flat rate pension to be set above means-testing levels there is now no longer a case for this. (Though as pensioners can also claim non-pensioner means tested benefits such as housing benefit and council tax benefit, this argument is not entirely sound.)

There are two types of drawdown. If you have enough regular pension income (£20,000) from other sources (some combination of the state pension, DB pensions or annuities) you can draw down as much or as little of your pension pot each year as you like – paying income tax on it as you would your other pension income. The budget reduces the pension income required from other sources to £12,000 – £5,000 more than the flat rate state pension of about £7,000.

If you don’t have sufficient other pension income the amount of drawdown is limited to 120 per cent of what you would have got from an annuity. This is to be increased to 150 per cent of an equivalent annuity, in what is an implied criticism of annuities.

There have been successive reports showing how badly the annuity market works. And they provide poor returns given that they have to guarantee income (guarantees are always expensive), particularly at a time when interest rates are low and look set to stay low. So it is hard to criticise the Chancellor for reducing the role of annuities – indeed they now look pretty optional for most people.

But many of these changes will encourage people to take lump sums out of DC pension pots, rather than a regular income. The Chancellor was strong on personal responsibility and trusting people to take the right decisions in his speech. This is good Conservative rhetoric but is in contrast to the whole direction of pension policy in recent  years which have been based on the insights from behavioural economics that people are in fact pretty useless at making long-term decisions. Indeed trying to work out how fast to draw down your pension pot when you do not know how long you will live is not easy, even if you are both numerate and financially literate.

Pensions policy should be about providing the retired with a reasonable standard of living. This should both lift them out of poverty and provide some continuity with their pre-retirement standard of living. There are many mechanisms that do this through state and workplace provision but in general the focus has always been post-retirement income. 

We are increasingly of the view that the way to improve DC pensions is to turn them into collective DC pensions as these are the most efficient way of turning savings into retirement income, where employers will not bear any of the risk.

But this budget goes in an entirely different direction. While many of its measures make some sense or are even welcome on their own, it is harder to argue that they improve the pensions system. Instead, they replace a pensions system with a savings arrangement. This might make sense for the relatively wealthy with high savings or access to DB pension income as well. It will also help those whose savings are too low to generate much pension income.

But there must be a big worry whether this is really positive for the great bulk of people building up savings in the middle, and very odd that there has been no real consultation or consensus building around this policy mix. It is unfortunate that such profound changes have been pulled out of the budget hat, rather than developed through the kind of national conversation that has given us auto-enrolment.

Perhaps we should have worked out that calling something ‘collective’ is not the way to appeal to George Osborne.