The decline of company final-salary pensions was inevitable. Even without Gordon Brown’s £5bn tax grab, often cited as the final nail in the coffin for occupational defined-benefit schemes, increasing longevity and a raft of changes to the rules were already making continued provision an expensive option for employers.
Now, just four FTSE 100 companies (Shell, Tesco, Cadbury and Diageo) offer a final-salary pension scheme to new employees, compared with 40 per cent of companies a mere five years ago.
For smaller firms, the situation is very similar. The Association of Consulting Actuaries reported in September that 87 per cent of DB schemes are now closed to new entrants and 18 per cent of those are also closed to future accrual. Trustees of 39 per cent of DB schemes are reported to be considering changes to future accrual for existing members.
This puts a huge burden on employees to take responsibility for their own retirement provision. Yet the ACA survey also found that 76 per cent of employers feel their employees are uncomfortable with taking on the investment, inflation and longevity risks inherent with defined-contribution schemes. An even higher percentage – 81 per cent – feel that employees are not capable of determining how they should manage DC saving.
Soon, however, even workers who have not in the past been willing or able to take on retirement planning for themselves are to have it thrust on them. From 2012, employers will be obliged to enrol employees in a pension scheme if they are not already in one. It remains to be seen how those who do not opt out cope with risk or if they will simply shut their eyes and resign themselves to the fortunes of a default fund.
Jonathan Hill, a chartered financial planner with solicitors Milton and Dormor of Chard in Somerset, says: “With state pension ages creeping up and longer life expectancies, consumers need to focus on pension planning for the very long term. From an investment perspective, the first challenge is selecting an investment that has a fighting chance of beating first, the underlying product charges and second, inflation, a hard act in anyone’s mind. This will require sound financial advice, consumer education or ideally both.
“A default investment option for a young inexperienced investor offering a low exposure to equities may tick the investment risk profile but is unlikely to provide much in the way of real return and that is just the first challenge.”
But Hargreaves Lansdown pensions analyst Laith Khalaf urges younger investors not to get too hung up on risk.
“Young people do not really need to minimise risk. It is probably quite right for them to be in equities in order to take maximum advantage of growth potential.”
For older investors, the situation will change. He says: “Ten years or less from retirement, you want to be able to rebalance your holdings with bonds, fixed interest and cash to avoid the dangers of being exposed to a downturn like the one we have just recently seen.”
Pension providers are trying to build automatic rebalancing into their products with features such as lifestyling, gradually switching investments into safer havens such as fixed interest and cash in the five or more years before retirement.
These are designed to minimise risk but they can actually do the reverse if investments are automatically shifted out of equities on a specific date that happens to coincide with a market downturn.
Khalaf says: “The problem is that lifestyled funds tend to be those aimed at the mass market. They are managed passively, with very little flexibility.”
Aegon head of individual marketing Gordon Greig says: “Customers’ needs and attitudes towards retirement today are significantly different to what they were in the past. Many people intend to carry on working past their normal retirement age because they feel too young to retire while others may be planning to phase their retirement in stages.”
Khalaf says: “Ideally, you should do your own asset allocation but at the very least you might be better off with a target date fund and have an adviser actively managing your shift out of equities.”
The risks facing pension savers do not lessen after retirement.
Khalaf says: “Since only a tiny proportion of savers take an index-linked annuity, the biggest risk a saver will face is inflation.”
An annuity that keeps pace with prices would, in theory, solve this problem but inflation-linked annuities give comparatively poor value in the early years. Additionally, many savers prefer to delay annuitising for as long as possible because of their aversion to handing over all their funds all at once to an insurance company.
Khalaf suggests that investors need to be more creative with their fund in order to combat risk. “The way to hedge risk is to use different pots of money to purchase difference products, such as a level annuity, a 3 per cent escalator and perhaps keep some cash invested.”
For most investors, annuitisation will eventually be unavoidable. Choosing an annuity with a guarantee can go some way to dispelling aversion to annuitisation but the risk involved in holding off on taking an annuity also needs to be brought home.
Khalaf says: “Customers taking drawdown are probably going a fair way to defend themselves against inflation by staying invested but they still run the risk of poor investment performance. It is essential that anyone using drawdown monitors income and does not take so much that the fund is depleted to the point of no return.”
An alternative to delaying annuitisation is using a third-way annuity product, a hybrid between an ordinary annuity and drawdown, which gives a guarantee on income levels.
Aegon pioneered this type of variable annuity in the UK in 2006 with its 5 for Life plan, which guaranteed a 5 per cent income for life from the age of 60. However, earlier this year, as a result of market conditions, the insurer was forced to withdraw the scheme and replace it with the Secure Lifetime Income Plan, which simply locks in increases in income levels and protects against falls without the 5 per cent guarantee.
Standard Life and Prudential both drew back from entering the hybrid annuity sector earlier this year, as the market deteriorated while US-owned The Hartford stopped writing new business in the UK.
Khalaf says: “The problem for these products is that the guarantees require derivative hedging and the costs of these have gone through the roof.”
Others providers have, however, soldiered on. Lincoln still offers its flexible guaranteed i2Live product, Living Time has a fixed-term product and Metlife offers its Retirement Portfolio products.
Savers near to retirement who fear a future collapse of annuity rates may be considering taking an annuity sooner rather than later to lock in to whatever rate they can get now. But Living Time managing director of sales and marketing Dave Harris urges pension savers not to annuitise too soon.
He says: “There are compelling reasons why, while it may be appropriate to reduce the investment risk in one’s portfolio, it may be a poor time to lock in to a lifetime annuity.
“Yes, quantitative easing is probably depressing interest rates but when interest rates do start rising again, this should push up gilt yields and allow annuity rates to improve.
“Nobody knows where annuity rates or inflation are heading over two or three decades, the kind of timescale retirees must try to cover. We do not think the uncertainty of 2009 is a good time to bet a whole pension fund on a lifetime annuity. People should be looking to optimally phase their purchase over several years, taking advantage of the fact that lifetime annuities may look far better value with greater age, and especially if one’s health deteriorates.”
Colette Dunn, head of the strategy group at consultancy Watson Wyatt, says: “With the current uncertainty in financial markets and individuals becoming increasingly aware of their need for sound financial advice, it is critical that IFAs are fully aware of all the challenges that people are facing regarding later-life provisions.”