The Budget 2014 given on 19 March announced a series of major (and unexpected) reforms to the tax regime governing the pensions market (for pension arrangements registered under the Finance Act 2004). The changes centred on the concept of increasing flexibility for members with defined contribution (DC) pension “pots” at the point of retirement: members would no longer be required under the tax rules to purchase an annuity at retirement (unless the member already had a minimum level of pension income), but would have more flexible access to their funds. This newsletter considers the main changes announced and their potential impact on the pensions and insurance markets.
Setting the pension reforms in context
In recent times there has been increasing government focus on encouraging saving, and in particular on sustainable pension provision. This has been a policy aim of not only the UK government, but also of broader EU initiatives.
In the UK, this follows a market shift from the provision of occupational defined benefit (DB) pension schemes to DC schemes (the so-called “demise of DB”). DB schemes are no longer seen, in many cases, as an appropriate choice for employee pension provision among corporates given the funding risks that they pose for scheme sponsors. DC provision has been the obvious fall back provision.
However, it is not clear that DC schemes will deliver adequate retirement incomes. This uncertainty has had a corresponding impact on demand for them amongst the working population.
The concerns relating to DC provision can broadly be divided into two “phases”: (i) adequate saving during an individual’s pre-retirement years (the accumulation phase), and (ii) the manner in which the savings can be accessed on retirement (the decumulation phase). The pension reforms in the Budget 2014 clearly address the decumulation phase, but with the aim that improving access to funds will make individuals more likely to save – the pensions consultation paper accompanying the Budget noted that in order to have the confidence to save, people need to know that they will get value for money for their savings.
Recent and prospective reform
There has already been significant legislative activity with the aim of increasing engagement in pensions saving, in particular the introduction of automatic enrolment and the simplification (from 2017) of the state pension system.
Automatic enrolment involves workers being automatically enrolled into workplace pension schemes (and given a choice of opting out) with minimum levels of employer and overall contributions set out in legislation. Over three million people have been automatically enrolled since July 2012, with opt out rates lower than predicted.
Simplification of the state pension
The government's white paper "The single-tier pension: a simple foundation for saving" (January 2013) suggested that the complexity of the existing, two tier state pension made it difficult for people to anticipate the level of their income in retirement, reducing the incentive to save. The government therefore consulted on simplifying the system, with the aim of making it easier for individuals to calculate their state pension entitlements and hopefully to increase the level of engagement that the general working population have with their retirement incomes. These changes are expected to be introduced by 2017.
Consultations and reviews
There is also the potential for future reform in view of various investigations and consultations which have been conducted in recent months.
- In September 2013 the Office of Fair Trading (OFT) market study on the DC workplace pension market found that the market is not working properly due to a very weak “buyer” side. In fact, it highlighted the buyer side of the market as one of the weakest it had analysed in recent years, resulting in a significant detrimental effect on consumers. A general lack of understanding by employees of pensions, the complexity of pension products and the misalignment of incentives as between employers and members resulted in a lack of scrutiny of the value for money of pensions. The OFT recommended (i) improving the governance of DC schemes; (ii) improving the quality of information available to employers and members; and (iii) a review of the charges levied on members (which the government has since consulted on).
- On 14 February 2014 the Financial Conduct Authority (FCA) published its Thematic Review of Annuities, which found that the annuities market is not working from a consumer perspective. This followed research conducted by the Financial Services Consumer Panel into the annuities market in late 2013 which highlighted the lack of consumer understanding of the annuities market and the lack of suitable information channels. Following these reviews, the FCA launched a market study into the structure of the market and supplier and customer behaviour, and intends to publish its preliminary findings in summer 2014.
- On 7 November 2013 the government also published a consultation entitled “Reshaping workplace pensions for future generations”. The aim of this consultation is to consider alternatives to the stark DB/DC divide and to consider new models of pension provision that may share pensions risk more equally between employers and employees. The various models proposed by this consultation can be described by the umbrella term “defined ambition”.
The issue of pension liberation has become more prominent in the last few years. It concerns the inducement of members to make transfers out of legitimate pension schemes into arrangements which allow them to access their funds before the normal minimum pension age (usually age 55). Enticed by the prospect of ready access to lump sums, a concern is that members may not be warned of the tax consequences.
Key changes announced in the Budget 2014
The changes announced in the Budget were described by the Chancellor as the most fundamental change to how people access their pension for almost a century. The most high profile change is that there will no longer be a requirement to purchase an annuity on retirement.
Prior to the Budget changes, the tax rules provided for the commutation of small pensions pots and for flexible draw down directly from the fund (provided minimum income levels are met). There was also the option of capped draw down, which provided that a maximum of 120% of the level of equivalent annuity that could be purchased could be drawn down.
The measures announced in the Budget make the system more flexible, with individuals with DC pension savings able to choose from three options:
- draw down (with the previous draw down limits/minimum income requirements removed);
- access funds as a lump sum (with more favourable tax treatment than previously); or
- purchase an annuity.
This fully flexible model is expected to be offered from April 2015. Interim measures, which took effect on 27 March 2014, retain the existing structure of flexible and capped draw down, but with adjusted limits.
There is also a proposal to increase the minimum pension age to 57 (from 55). The government is consulting on this and on proposals for the minimum pension age to track increases to the state pension age.
To a certain extent these changes address some of the attractiveness of pension liberation schemes, as individuals will have greater access to their funds without resorting to pension liberation vehicles - though the changes do not address their “ability”, provided by pension liberation schemes, to access their pension funds prior to the minimum pension age. Other changes announced in the Budget give HMRC greater powers as regards pension liberation schemes.
April 2014 Consultation
There are some specific issues to be considered about the detail of the proposals and how they will be implemented. These are the subject of a government consultation paper issued on the same date as the Budget 2014.
Consumer choice and guidance
Annuities remain the only products which provide a guaranteed income for life. Accordingly, annuities form a considerable source of both new business and in-force profit for insurers. A significant number of individuals depend on the protection offered by guaranteed income products which, for them, underpins the basis of a secure retirement. Ascertaining the base level of this guaranteed income will vary on a case-by-case basis. Accordingly, it will become increasingly vital for individual consumers to be properly informed of their choices in order to enable them to make the right investment decision.
The government has proposed the introduction of a new requirement to help individuals make the investment decisions that best suit their needs upon retirement. In effect, everyone who retires with a DC pension will be offered “free” and “impartial” face to face guidance on their retirement options which will take effect from April 2015. Given that the average pension pot size in the UK is £30,000, the proposed “free” guidance is unlikely to take the form of detailed investment advice and, indeed, a spokesperson for the FCA has stressed that the support provided to retirees “will be guidance, not regulated advice, and as such is likely to explain the different options at retirement and their implications, but will not recommend specific products”. The FCA will be working with interested parties to develop “an appropriate guidance framework”.
The government has committed £20 million to fund the establishment of a “guaranteed guidance” service, however it is not clear how this will be funded in the long term. There is a likelihood that DC pension members will end up paying (despite separate proposals to cap the level of charges levied on DC scheme members).
One of the key findings of the FCA’s Thematic Review of Annuities earlier this year was that the majority of consumers who purchased an annuity from their existing pension provider could have obtained a better rate if they had shopped around. There is a lack of understanding surrounding annuities and pensions in general, and a number of people, perhaps as a result of the perceived complexities, do not fully engage with the process and do not necessarily have the information to help them make the right choices. Inertia prevails. From 2015, retirees will be forced to decide whether to take an annuity (and if so the type) or not and, if not, what to do with their cash lump sum. There will be no room for inactivity and individuals will be forced to take responsibility for their own retirement planning.
Given the potential increase in choice for individuals, regulated providers of investment products will have to be all the more aware of the need under FCA principles to pay due regard to the interest of customers, to treat them fairly and to take reasonable care to ensure the suitability of any advice given. The government has asked the FCA to work together with the Department of Work and Pensions (DWP) to ensure that the guidance in this area meets robust standards. The FCA will no doubt need to bring forward its review on annuities and indeed the government has made it clear that it looks forward to seeing the outcome of the FCA review.
What about those with DB pension pots?
The consultation also considers the position of members of DB schemes who may wish to transfer to DC arrangements to take advantage of the increased flexibility in the DC regime. The government has already said that its preference is that transfers will not be permitted, except in limited circumstances, of DB entitlements from the public sector into DC schemes. The consultation asks for responses on how private sector DB pensions should be treated.
On the one hand, it seems unfair to offer flexibility to those with DC pensions but not DB pensions. However, the economic impact of allowing DB pension holders to transfer into DC schemes and take advantage of this flexibility is unclear. For example, it may lead to liquidity issues for DB pension schemes which are likely to be invested in longer term income-producing assets to match the pension scheme liabilities as members mature. DB pension funds’ investments also play a key part in the wider economy (for example by investing in gilts, corporate bonds and infrastructure projects). That investment pattern may need to change if transfers are allowed.
There are broader issues around the consistency of the Budget announcements with previous legislative amendments.
It has been widely reported that the philosophy underpinning the flexibility proposals is to allow individuals to have greater control over the use of the pension savings. There has been much press comment about these policies treating savers as "grown ups" and Ministers have been keen to stress that they believe that individuals will be financially responsible in exercising the flexibility. This is in response to criticism that the new proposals could lead to increased burden on the State should pensioners effectively "spend" their retirement pots too quickly.
This position contradicts existing policy in two respects:
- Automatic-enrolment policies were formulated on the basis of behavioural economic norms that suggested there was a level of inertia among workers. Hence the decision to automatically enrol and require workers to opt out, rather than requiring workers to be given the choice to opt in. This does not fit with the idea that that Ministers believe individuals to be inherently financially responsible.
- The industry codes of best practice in respect of enhanced transfer value exercises warn against the use of cash in these exercises as research shows that members are likely to be induced by the cash offer to transfer. Again, this is contrary to the idea of a truly “financially responsible” member and instead is rather more protectionist.
Although arguably a change of approach for the UK government, the idea that people take responsibility for the financial planning of their own retirement is not new. The high annuitisation rate in Switzerland (80%) demonstrates that voluntary annuity uptake remains relatively high even where retirees are given the option to take an annuity or to take their pensions in a lump sum. Since 1992, pension saving has been compulsory in Australia and upon retirement most people choose to turn their pension savings into retirement income rather than to take a cash lump sum. It appears that when it comes to retirement planning individuals are not necessarily prepared to take sizeable risks with their pension pots. Further, it seems unlikely that the government (through the DWP and FCA) would permit the presentation of higher-risk investment options to retirees without adequate safeguards or warnings, particularly if such options ultimately risk increasing the number of people who will deplete their pension funds prematurely and seek to rely on a state-backed pension.
Individuals are aware of increasing longevity and the risk of depletion of their pension assets too early in retirement. This will undoubtedly result in a number of individuals who seek a retirement product which provides the certainty of income until death.
One of the concerns that auto-enrolment was intended to address was the adequacy of pension income for individuals in view of an ageing population (causing an increased burden on the State). Auto-enrolment addresses this concern to a certain extent at the point of accumulation of pension savings. However, if the result of the Budget 2014 announcements is that fewer retirees take out annuities, where those retirees either underestimate their life expectancy or are financially irresponsible in how they spend their pension savings, that seems to create a new issue around the adequacy of pension income at the point of decumulation.
Implications for the UK life insurance market
The market impact of the 2014 Budget is, naturally, as yet unknown. However, annuities form a significant part of the business carried on by a number of UK life insurers and the changes made to the options available to individuals upon retirement will no doubt have long-term implications for the UK life insurance market. The annuity market has traditionally been a profitable market, worth approximately £12bn per annum. Although it may shrink, there is certainly scope for development and innovation of new retirement investment and draw down products. Nonetheless, the uncertainty surrounding the future of the annuities market and the longer-term impact of the Budget, both in terms of new rules and potential consumer choices, is one of the key challenges faced by the UK life insurance industry.
Annuities going forward
Individuals will have the flexibility to take their retirement benefits as a lump sum, to take an annuity or to invest their retirement benefits in any way they choose. As mentioned above, a number of individuals are likely to continue to demand products which provide a guaranteed income stream throughout retirement. However, it is likely that a proportion of retirees will choose to take the cash as a lump sum. It can be assumed that the size of the individual’s pension pot together with the health of the individual will be significant factors in the decision making process. Individuals with smaller pot sizes or lower life expectancies may be more likely to cash their pension pot than individuals with larger pot sizes or higher life expectancies and accordingly the market for annuitisation of smaller pots will shrink. However, the market for annuitisation and / or investment in alternative investment products should remain active.
What we can expect to see, however, is increased competition in the sector. As mentioned above, the FCA’s Thematic Review of Annuities has drawn attention to the fact that compulsory annuitisation has not always worked to consumer advantage and individuals have not necessarily been benefitting from the best rate. This issue is compounded by various factors, including that the Bank of England’s quantitative easing policy has, in recent years, contributed to a sustained period of low interest rates and, in turn, lower annuity rates. Recovery and a tapering of quantitative easing are likely to lead to higher annuity rates (although the consensus is that interest rates are likely to remain relatively low) and ultimately to annuities becoming more appealing.
However, in the short to medium-term, insurers will need to explore and offer alternative savings and / or investment products to plug any shortfall from a reduced uptake of annuities and to remain active and competitive in the retirement planning market. A number of insurers and annuity providers have already started considering innovative annuities products and are considering the extent to which annuities can replicate investment whilst also providing a guaranteed element. Product innovation from an insurer’s perspective could include an exploration of:
- Variable annuity products: guaranteed minimum benefit products underwritten by an insurer which allow investors access to their capital and also a level of guaranteed income.
- With-profits retirement policies: although with-profits policies have fallen out of favour recently, it will be interesting to see whether new with-profits products which provide a guaranteed income stream emerge.
- Transfer of longevity risk: transferring longevity risk from individuals to insurers who can pool longevity risk. Such pooling will help to balance the savings of those individuals who die earlier than expected with those who outlive the average life expectancy.
- Asset backed / index linked annuities: the attractiveness of asset backed annuities and index linked annuities would perhaps be increased if they offered more flexible draw down options and the option to switch underlying investments.
- Account-based pensions: since 1992, there has been considerable product innovation in the Australian market. The Australian government identified that the most popular income stream product is what is known as an “account-based pension”. People are given the option to choose how much money they wish to draw down each year (subject to a statutory minimum). Their account earns income from the underlying assets it is invested in, although the value of the account can increase or decrease depending on the performance of the underlying investment.
For many large UK life insurers diversification, both in terms of product offering and geography, provides a hedge against the impact of any reduction in individual new annuity business. Any new product innovation will inevitably require government and regulatory support if individuals are to be encouraged to invest their pension pots rather than to spend the cash lump sum too early on.