Pensions
You’re on your own
Ian Neale, director at Aries Insight , foresees rebalancing of risks for retirees
H ow would you feel if someone said to you “You’re on your own”? Uncomfortable? Even if you felt ‘okay, no problem’, I dare say doubts might creep in later. For employees retiring in the private sector, increasingly that’s the reality today. Some have a deferred final salary-type pension from a past employment, but many have just a money purchase pot; and what to do with it is up to them. If you work in the private sector today, the chances are you’ve been auto-enrolled into a defined contribution (DC), also known as money purchase, pension scheme; either a master trust, a group personal pension (GPP), or a trust-based scheme run by your employer. Your options on retirement will depend on the scheme rules, but broadly speaking there are four ways to convert this pot into income. The first is to use the money to buy an annuity; and before ‘pension freedoms’ exploded onto the scene in 2015 most people had to do this. It wasn’t and still isn’t popular, mainly because your money dies with you, unless you buy a joint-life annuity. Though they provide a guaranteed income for the rest of your life – which is what most retirees say they want – annuities are often regarded as poor value for money. Pension freedoms created alternatives: partial or full encashment, or drawdown. A cash payment from a pension scheme is called an uncrystallised pension funds lump sum (UFPLS), of which 25% is tax- free and the rest taxable at your marginal rate – which because HM Revenue & Customs insists on ‘week/month 1’ treatment means 40% or 45% in most cases. Great news for HM Treasury; but not so great for the taxpayer who might
otherwise have been only paying 20% tax on income for the year. At this point it’s worth mentioning the helpful role payroll or human resources can play in giving factual information about retirement options, because typically in a trust-based DC scheme an UFPLS is the only alternative to annuitisation; and some schemes insist on full encashment. What to do with the cash is up to the retiree, of course. ...helpful role payroll or human resources can play in giving factual information... An employer can do a bit more to help, though; including, arranging to pay for some financial advice (which I wrote about in the April issue; page 37). Here I want to say more about drawdown, and then look ahead to better solutions. While few trust-based DC schemes are willing to offer drawdown, most master trusts are, or soon will be (and so are GPP providers). Therefore, if neither an annuity nor an UFPLS is attractive, the member will have to transfer out to a scheme of their choice. Then comes the hardest decision of all: how much income to take? The reality at the moment is that most dodge this decision initially; they take the 25% tax-free cash to which they’re entitled and leave the rest in the pot. Sooner or later though they will have to start drawing income. To avoid running out of money in later life, how much is ‘safe’ to draw is the $64,000 question. Received wisdom for many years, derived from long experience in the USA,
has been 4% per year, increasing in line with inflation; but that’s not sustainable in a world of enduring ultra-low interest rates, gilt yields and quantitative easing. Data from the Financial Conduct Authority shows that six in ten of those in drawdown with pension pots over £100,000 are still drawing 4% or more per year. Unless they stay heavily invested in equities, there is a significant chance of exhausting the pot before death. To avoid that unpalatable prospect, income drawdown might have to be slashed by a quarter. The value – and, of course, cost – of expert financial advice becomes clearer; and so does the impact of fees and charges in general, which can easily amount to 2% pa. The compound effect of this in diminishing the pot over several decades of retirement is quite breathtaking. So, drawdown is, in lots of ways, risky. In fact, as a recent report by the Institute and Faculty of Actuaries (IFoA) makes clear, over recent decades there has been a huge transfer of risk – particularly longevity risk – from institutions to individuals now confronted by the need to manage risks they did not have to worry about previously. The IFoA is pushing for a rebalancing of risks, recommending government action not only to make decumulation pathways (i.e. cash/drawdown/annuity) a default option for all DC pensions, but also to facilitate collective money purchase. The latter is known as collective defined contributions (CDC) arrangements, which offer members what they most really want: an income for life in retirement. It will be do-able for large DC providers, including many master trusts. Pooling of risks is making a comeback, mark my words. n
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| Professional in Payroll, Pensions and Reward |
Issue 71 | June 2021
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