Risks and Challenges of Freedom and Choice in Pensions

23 Oct 2024

Arguably, the most significant thing that George Osborne did for pensions during his lengthy tenure as Chancellor of the Exchequer was his declaration in the 2014 Budget speech: “Let me be clear: no one will have to buy an annuity”. The full set of reforms came into effect in April 2015, giving DC pension savers at retirement an un-restricted choice between income drawdown, annuity or cash.

This landmark reform is usually referred to as ‘Freedom and choice in pensions’. That title was also conjured up by George Osborne, as it was the headline grabbing name given to the Command Paper presented to Parliament on the reforms within the 2014 Budget pack. However, a more balanced name for these landmark reforms might have been ‘Freedom, Choice and Consumer Responsibility’.

Before the reforms, for most ordinary people the output of a working life spent in DC schemes was a 25% tax free cash sum and an annuity. HMRC watched closely over pension schemes paying out more cash than this. While both the Bank of England and the FCA supervised annuity providers to ensure that once annuity payments had commenced, pensioners felt absolutely secure they would continue through to their death and even to the death of a partner beyond that for joint life annuity holders.

However, in the very moment that the decumulation choice rabbit jumped out of the hat on Budget Day some 10.5 years ago, the real responsibility for DC retirement income jumped from the government to individual scheme members.

This was done for the members’ benefit. The main thrust of the then government’s argument was that the nature of retirement was changing, and it was right to give people much greater flexibility over the timing and manner of taking their retirement income. However, the Command Paper also noted that it would lead to a change in the way that decumulation assets were invested.

Much of the pensions savings money that would have, under previous rules, flowed into corporate bonds and gilts following annuity purchase, would likely now be invested in the range of funds offered by drawdown providers, including a proportion into equities and other growth assets. In this respect George Osborne may have been 10 years ahead of his time, as current and recent Chancellors have been encouraging a switch of pension assets towards a focus on growth assets.

New normal for DC retirees

Ten years on we can now see the result of the reforms, as a new normal for DC retirees has emerged. Comprehensive data is provided by FCA’s regular publication ‘Retirement Income Market Data’. The latest such data covering the year to March 2023, shows that annuities remain a popular choice, with 59,000 annuities purchased by people who have actively chosen that this is what they want to do, rather than something that they felt they had to do. However, this number is dwarfed by the 218,000 new income drawdown plans established in that same year. A new preference has emerged, with DC savers retaining control over their savings as they move into retirement with income drawdown.

More worryingly for the pensions market, nearly double this number - some 420,000 pots in all – were fully cashed in at retirement and 90% of those fully-cashed-in pension pots had less than £30,000 in them. This is why there is a separate legislative programme that hopes to automatically consolidate small workplace pension pots with the bulk of an individual’s lifetime saving so that those monies can more efficiently become part of the pensioner’s regular income in retirement.

The transition that we have witnessed from annuity to drawdown as the predominant form of DC retirement income has passed the responsibility for managing the associated risks to the consumer. Those risks can be classified in four key ways: sustainability, inflation, investment and longevity.

Sustainability risk

If the pensioner takes too much out early on, then the drawdown pot will be irreversibly depleted and will run out, or reduce to a trickle, in later retirement. There are many tools and rules of thumb to help manage this but perhaps the best known is the 4% rule that annual withdrawal amounts should not exceed 4% of the pot value on retirement and then increase annually with inflation thereafter. However, with FCA’s latest data showing that two in every five drawdown customers – 40% of them – are making regular withdrawals totalling 8% or more of their pot value per year, sustainability is a genuine long term concern for the drawdown market.

Inflation Risk

It is a commonly held misconception that pensioners will be spending less by the time they reach their 80’s. Annuitants seem to think so: the FCA data shows that 85% of annuities are purchased on a level, non-escalating basis. Yet the recent IFS paper entitled ‘How does spending change through retirement’ drawing upon longitudinal ONS data, shows that pensioner expenditure increases faster than inflation up to age 80 and carries on increasing , albeit more gently, after that milestone is reached.

Investment Risk

The clever insurers that have issued annuities for over two centuries understand investment risk and buy safe assets with predictable cashflows that match the timing of payments out. By contrast, drawdown customers are offered a range of funds, with more or less volatile equity-based assets at their core. These funds have often been constructed with accumulating customers in mind, rather than the decumulating pensioners they must now serve. These funds can exhibit rapid price falls, and if the pensioner makes withdrawals when prices are low then they will be cashing in rather more units than they might have anticipated in their financial plan.

Longevity Risk

This one is a key challenge which is not helped by some of the simpler tools or guidance on the market. It is far too simplistic for a member at retirement to be thinking about a single point like the age they expect to die at. I can’t hope to turn every pensioner into an Actuary after all. However, people do need to understand that there is a rather wide window of ages at which their death is likely. If they only plan for their longevity mid-point then 50% of them will run out of money before they pass.

Ten years ago, the then government also offered guidance to individuals and encouragement for the market to launch new innovative products better suited to the needs of retirees. The guidance service is good but not used by enough people.

Furthermore, product innovation has been slow. But today, more than 10 years on, there are encouraging signs that new ideas like blending annuity with drawdown, and a decumulation version of Collective Defined Contribution schemes will, within the next 10 years, provide a rather richer and more suitable range of choices for future retirees.

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