Feathering nest

February Retirement Strategy | By Gregor Watt

The files and boxes of research reports that line the wall of Pension Policy Institute director Niki Cleal’s office read like a timeline of pension reform, both planned and implemented, over the last 10 years.

With an election this year and all the main parties starting to outline their polices and, of course, the introduction of auto-enrolment in 2012, there is no shortage of subject matter for the PPI to get its teeth into.

But the looming election seems to be something of a double-edged sword for the PPI. The need for independent information and analysis of pension policy becomes even more important but the institute has to be very careful how it presents itself as it is very protective of its independent statuts.

Cleal says: “We are not a lobbying organisation, we are not a trade body-type organisation that will lobby Government and call for a particular policy and solution. We are really about getting the facts and the evidence out there to enable others, mainly policymakers, politicians, MPs, to make well informed decisions.”

But this does not mean that the PPI steers clear of the controversial topics. Although you get the opinion that Cleal does not envy the politicians and decision makers that the PPI’s research work helps to inform, the institute regularly contributes to the all the debates on all the major policy issues.

Cleal says this Government’s flagship policy of auto-enrolment will radically change the structure of retirement saving in the UK. While there is still a lot of discussion on some of the key decisions, she says the most important decision has already been taken.

Cleal says: “The big change in the Government’s pension reforms is, in my mind, the introduction of auto-enrolment. It is not really about the introduction of personal accounts or Nest. I think the big change here is the presumption that people will be in a pension scheme unless they decide to opt out. We can anticipate significant change in the pension andscape because of the this - the Government’s estimates are somewhere in the region of four to nine million people might come into pension saving for the first time as a result of these reforms. That does seem to me to be entirely feasible.”

When you are talking about rela-tively low to modest earners, you have to recognise that these are not people who can afford to lose large chunks of a relatively modest savings pot

Cleal says the design of the charging structure and the investment options are going to be important to the eventual success of Nest but she says the role of the media in informing the public is going to be much more crucial to the success of the scheme at its launch.

“The question is, once people have been auto-enrolled, do they stay auto-enrolled or do they opt out? I think there are a number of things that will come into play there. One is, what is the media comment and discussion about pensions and Nest at the time of the launch? If there are scare stories of people not being better off as a result of saving or if there are individual cases of something going wrong, then the risk is that encourages more people to opt out and you end up with lower numbers of people participating in pension saving.”

Cleal says choosing the design of the scheme charges is an awkward decision to take because the different options tend to favour different types of people. But while this an important decision, she says it is unlikely to be critical to the scheme’s success.

The design of the investment options for Nest will, however, be critical to the long-term success of the scheme.

Cleal says: “The structure of the default investment fund will be very, very important because all the international evidence is that you can anticipate that 80-90 per cent of the people who participate in Nest might go into that default investment fund. So getting the design right for that is going to be a huge challenge. There is clearly a balance there between realising that pensions are a long-term product and that might push you towards taking investment risk but on the other hand recognising that volatility and wild swings in performance from year to year might encourage people to opt out. There is a balance between those two things and getting that balance right is difficult.”

On the whole, Cleal says she favours a more cautious investment approach, where the elimination of volatility is a higher priority than strong investment performance.

“When you are talking about relatively low to modest earners, you have to be very careful about what investment strategy you pursue. You have to recognise that these are not people who can afford to lose large chunks of their relatively modest savings pot.”

But Nest is only one issue that the PPI is looking at. The other big issue for the election is likely to be the age at which people retire. The Conservatives’ recently published economic manifesto puts increasing the basic state pension age as one of their key policies and the Government has also been reviewing evidence on the default retirement age.

Cleal says the demographics alone mean that people are going to have to get used to the idea of working longer than they do now.
The Government has already legislated for increases in the state pension age, increasing it incrementally to 66 from 2024, then to 67 and then to age 68 by 2046 but Cleal says only time will tell if this rate of increase will be fast enough. The improvements in life exp-ectancy we have seen, even in the last two or three dec-ades, are staggering. In 1981, a 65-year-old man could have expected to live a further 14 years. By 2010, that has increased to 21 years. That is an additional seven years ’retirement’. If you still focus on a fixed retirement age of 65, obviously that additional seven years has to be paid for somehow and it is inevitable that as a society, we are going to have to start rethinking retirement, that we might need to be more flexible about phasing in retirement and I think it is inevitable that people will have to work longer.”

Allied to longer life expectancy, the continued move away from defined-benefit pensions mean that the affordability of retiring at age 65 may be beyond many people’s means.

Cleal says: “We have to realise that there are some fundamental changes that are going on here and while it would be very nice to be able to say we will all retire at a fixed age, in reality, that needs to be kept under review. As the evidence changes and as we start to live longer, retirement ages will need to rise.”

But Cleal says this need to increase the retirement age does need to be handled with care so as to allow people consistency and a suitable timescale for their financial planning.

She says: “If life expectancy is going up much faster than we expect, then maybe the state pension age needs to go up faster. At the same time, that has to be balanced against recognising that governments do need to give people some planning horizon, that people cannot respond to a change in either state pension age or indeed normal retirement age overnight and those two things have to be balanced.”

Another issue that goes hand in hand with increased longevity is the different need for income that people may experience if they live long into retirement. The PPI has just published the last in a series of research papers on retirement income and assets. In the first report, the PPI suggested that longer lives mean that the traditional way of looking at funding for retirement may be outdated as ill-health and long-term care start to become a more common concern.

Cleal says: “It is very hard to generalise but when you look at average patterns people tend to have an early active stage, maybe in their late 60s, and that might mean they need and indeed want to have sufficient income to support that active lifetime. That tends to tail off into the 70s as mobility declines but if people either acquire a disability or require some form of long-term or residential care in their late 80s, their need for income may increase very sharply in those later phases.

“When you think about conventional pension products, the obvious one being a level annuity, the profile of income that gives someone is very flat. It does not vary in that way. That may not matter if people have other assets and other sources of income which they can release to meet these other peaks. But it does mean thinking about retirement differently and not as that we have a fixed linear amount of income we need in that same way year, after year, after year because I don’t think that reflects what the real world looks like.”

The Government’s current review of funding for long-term care has proposed several different options and Cleal says the final decision could have a significant impact on how people plan for retirement.

“That debate is highly relevant to the general discussion and issue around retirement planning because, depending on which model is adopted, that could have very different implications for some indiv-iduals in terms of how much of a contribution from their retirement resources might they need to dedi-cate to care.”

The PPI has also been doing a lot of work looking at the range of assets and savings, not just traditional pensions, that people are accumulating and how these can be combined to pay for retirement.

For example, last year, the institute had a long look at the role that housing assets could play in retirement and the final report in the income and retirement assets series, which is published this week, tries to tie up all the different elements that go towards planning and funding retirement.

“We all fall into this trap of talking about pensions and savings over here and then there is another deb-ate over here and what will happen about social care. Often, they don’t come together. One of the things the PPI has been trying to do with our retirement income and assets series is to try and bring these two debates closer together.”

We all fall into this trap of talking about pensions and savings over here and then there is another debate over here and what will happen about social care. Often, they do not come together

After looking at the whole series, Cleal says the traditional way of funding retirement is changing rapidly, with many people having to use a range of different assets and forms of saving to meet their needs. But the upside of this, particularly for IFAs specialising in the retirement market, is that the need for advice and information to help savers deal with the complicated and fragmented savings picture has never been greater. While Cleal predicts that the lowest earners will continue to receive the majority of retirement income from the state, she says there will be a rapid increase in the number of people needing advice.

She says: “If you look at low earners, the majority of their income is likely to come from the state.

“You’ve then got a middle group of middle earners. The value of the state pension will be higher in the future because of things like basic state pension being re-indexed to earnings and some of these policy changes we are expecting. But they also have some private pension saving that might be a mixture of legacy DB and it might be a mixture of defined-contribution entitlement. Our projections are for a very rapid increase in the number of DC savers from around five million today to more like 17 million by 2050. The pensions landscape for them, I think, is going to be quite complex once they get to the point of retirement and have to translate some of this stuff into an income.

“The need for information and advice is going to be ever more important because we are looking at a pensions landscape that is more complex and people are going to have different pots of assets in the future. There is a real role there for information, communication and advising people as to what is the best course action for them.”

Another factor that further complicates the decision-making process is the continued presence of means-testing. The PPI is not as gloomy on the potential growth of means-testing as some commentators and Cleal says their projections suggest that between 30 and 40 per cent of people could eventually receive means tested benefits.

But, like many issues the PPI looks at, she says there are no easy solutions. You can simplify the problem but the solution is not always easy to put into practice.

“You could completely eradicate means-testing at one extreme but that then gives you a very difficult policy question of what do you do for people who haven’t saved for their retirement. Or do we go the other way and have complete universal state benefits, which is extraordinarily expensive. I think any system, no matter which party is in power, will have some element of means-testing in it. I don’t think you can entirely get away from that. It is more a question of the degree.”

The Government has started chipping away at pension tax relief in the last year and Cleal says that without a doubt the current system of incentivising saving pays out more to higher earners. She points out this is only one way to incentivise savings but says it is ultimately a matter of politics as it depends on what a government is trying to achieve.

“There are other ways of incentivising pension saving. We did some work in 2004 for Age Concern which was looking at matching contributions and there is some evidence from the Saving Gateway experience that lower earners respond more favourably to the idea of ’well, you put in a pound, someone else puts in a pound,’ and that kind of concept is easier to relate to and is easier to understand than what can seem like a rather esoteric far-off tax relief thing, that people find difficult to relate to.

“You could harmonise the current system at a rate between basic-rate tax and higher-rate tax. There would be winners and losers, obviously, from that.

“So there are different ways of delivering tax relief. It is a difficult one and ultimately it comes down to the politics in pensions. About who are we trying to incentivise to save in pensions?”

The rate of pension reform looks unlikely to slacken over the next few years. It looks like Cleal will have to find room for even more files on her bookshelves.

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