In days gone by, the one thing most people did not have to worry about when it came to pension planning was how long they might live. If you were a member of a defined benefit scheme, then the pension lasted as long as you did. If you had a defined contribution pot, then you would usually use it to buy an income for life. Either way, living longer than expected was a headache for your pension scheme or annuity provider but not for you.
In the world of freedom and choice longevity risk now falls increasingly on the individual. The good news is they can go on investing their money much longer than in the past, potentially earning a better return. But the bad news is they now have to think about how long they might expect to live, as well as about what they would do if they lived significantly longer or shorter than this.
One of the big problems unadvised individuals face is people generally under-estimate how long they will live. There are several reasons for this. One is (to the extent we consider these issues at all) we tend to think about our parents and grandparents and how long they lived, and use that as a guide to our own expectations. However, given the onward march of longevity, the length of time our grandparents lived is a pretty poor guide to how long we will.
A second reason we get it so wrong is figures we hear in the media for “average” life expectancy are often answering a totally different question. For example, a simple internet search of the term “average life expectancy UK” shows a headline from Autumn 2015 which states: “Average life expectancy in England rises to 81 years.”
Now, those involved in advising people about pensions will know a man or woman aged 65 making “at retirement” choices would be very unwise to plan on the basis of only reaching 81. In fact, according to the Office for National Statistics, a 65-year-old man can expect to reach 86 on average, and a 65-year-old woman to reach 89.
“We are likely to see product innovation in the drawdown space as providers look at investment strategies”
The discrepancy between these numbers arises because one relates to life expectancy at birth, while the other is your life expectancy having survived to 65. Although the former is of general interest, the figure of 81 years would be a very poor guide for retirement planning.
There is also the important issue of variations around the average. Returning to our example of a 65- year-old woman, the ONS estimates one in 10 of such women will live to 100 and an astonishing one in four will live to 96. Given people systematically underestimate their longevity and face considerable uncertainty around the true average, what does this mean in a world of freedom and choice?
First, it is clear products that reduce or eliminate longevity risk will continue to have an important role to play in the market. It is not entirely surprising to see the latest data from the Association of British Insurers suggest annuity sales are already starting to recover from their slump after the 2014 Budget.
But there are other ways of dealing with longevity risk apart from locking straight into an annuity at pension age. In particular, we are likely to see product innovation in the drawdown space as providers look at governance and at investment strategies to make sure they remain suitable in this new world. The goal must be to allow consumers to get the maximum benefit from the new pension freedoms and the potential to stay invested for longer but without sacrificing the peace of mind annuities used to give.
While the freedom not to buy an annuity was a welcome one, making sure consumers are able to cope with longevity risk remains a work in progress for providers and advisers alike.
Steve Webb is director of policy at Royal London