Freedom to choose
Before the changes were announced in Budget 2014, three-quarters of people with DC pension savings used them to purchase an annuity, with an average-sized pension pot of £35,600.
This was strongly encouraged by pension tax legislation, which applied a 55% tax charge on lump sum withdrawals except in limited circumstances.
The advantage of annuities is that they provide a guaranteed income throughout retirement, reducing the likelihood that individuals exhaust their savings prematurely and have to fall back on the state.
However, the popularity of annuities has declined in recent years, in part due to falling annuity rates, but also because of emerging evidence that parts of the market did not work well for consumers.
In Budget 2014, the Government announced that from 6 April 2015 it would allow people aged 55 and over more flexibility about when and how to draw their DC pension savings, and face their marginal rate of income tax, rather than the 55% rate.
Announcing the policy, the Chancellor said that people “should be trusted with their own finances”. The Government also argued that the introduction in 2016 of a new state pension set above the ‘basic means test’ meant that the state could be much less prescriptive about how people used their pension pots.
With choice comes responsibility
Although many have welcomed the increase in flexibility, there are concerns that it will place a significant burden of responsibility on individuals, requiring them to make complex decisions, taking account of longevity, inflation and investment risk, and the implications of withdrawals for tax, entitlement to means-tested benefits and help with social care.
They will also have a wider range of options to choose from, including products that may be complex and difficult to compare in terms of value for money.
There are also concerns about the potential for mis-selling, particularly of riskier investments and ‘too good to be true’ scams.
To help people make informed decisions, the Government introduced a new guidance service, Pension Wise. This would inform retirees of the different options, rather than recommend a particular product or provider. The service was welcomed as essential to the success of the reforms.
However, its effectiveness will need to be monitored, given the very tight timetable to get it up and running.
Concerns have also been raised about what happens when people come to choose a particular provider or product. This led the Financial Conduct Authority (FCA) to announce a ‘second line of defence’ for consumers: when a customer contacts their pension provider about their pension, as well as recommending guidance, providers are required to ask consumers about circumstances related to the decision they are making, such as health, lifestyle choices and marital status.
The impact of the reforms, particularly on incomes in later retirement, will not become fully clear for many years. It will also take time to see how the market responds, and whether people will be able to buy products, besides annuities, that provide a secure income at an appropriate price.
The announcement of the reforms saw a significant drop in demand for annuities, though this may in part reflect people delaying a decision until the reforms were introduced. The longer term effect is still difficult to predict and will depend on how consumers and the market respond.
Chart: Number of annuities sold by quarter
The announcement of the pension reforms saw a decline in annuity sales. Number of annuities sold by quarter, Q1-2010 to Q4-2014, thousand
Products allowing greater flexibility seem likely to form a larger share of the market in future. It is also possible that annuity rates may fall further if those opting to buy them tend to have higher life expectancies.
The FCA found that consumers showed a tendency to move away from annuities, preferring some form of flexible drawdown option (although for those with an average pension pot the right annuity could represent relatively good value for money and be a good option for those with a low appetite for investment risk).
Some may decide to opt for other financial products, assets such as housing, or to finance immediate spending. On the other hand, pension saving could increase, since individuals will have more flexible access to these tax-efficient savings.
Because the behavioural response to the changes is uncertain, so is the impact on the Exchequer. The Government expects increased income tax receipts in each year until 2030, based on the assumption that 30% of people will draw down their savings at a faster rate.
The Office for Budget Responsibility certified the Government’s calculations of the tax impact, but said the effects were “subject to very considerable uncertainty”.
Types of pension arrangement
Defined benefit (DB) schemes promise to pay pension benefits based on fixed factors, typically salary and length of service. Defined contribution (DC) schemes pay out a sum based on the value of a member’s fund on retirement. The level of pension depends on factors including the contributions invested, the returns on that investment (minus any charges applied) and the rate at which the fund is converted to a retirement income.
Changes for existing annuity holders?
In its final Budget, the previous Government announced plans to allow the five million individuals already in receipt of an annuity to sell the income they receive from it in return for a more flexible arrangement or a lump sum. The intention was to extend the option of flexible withdrawals to people who had already bought an annuity. It remains to be seen whether the new Government will take forward the proposals, and if it does, whether a functioning market in “second-hand” annuities will emerge.
- Conservative: allow flexibility about when and how to access pension savings
- Labour: allow pension flexibility but ensure proper guidance to prevent savers being ripped off or hit by scams and mis-selling
- Liberal Democrats: press ahead with pension freedoms and allow existing pensioners to sell their annuity
- SNP: continue to support pension flexibilities in principle, but work to ensure adequate advice and support
- UKIP: allow pension flexibility but fund a higher standard of independent advice to support decision-making; action to prevent mis-selling