Who said pensions policy is boring? The ‘annuities deal’ – tax-favoured pension savings must be used to provide a secure pension income – has been the cornerstone of UK pensions policy since the Finance Act of 1921.
Last week, with no warning or discussion, the Government tore up the annuities deal by removing punitive tax-charges for fully cashing-in DC pension pots.
In the manner of its announcement, the Government also effectively scrapped the cross-party, consensual approach to pensions policymaking that has held since Lord Turner’s Pensions Commission, and which is typically seen as essential if the public are to be confident that rules on pension saving won’t be revised every time there’s a change of Government.
The Chancellor and various commentators have trumpeted the “liberalisation” of people’s pension savings in the Budget, and poured scorn on those who “don’t trust” retirees to manage their finances.
This is all guff. Most people are not actuaries, and so the idea of letting people take “responsibility” is actually pretty vacuous given no one can know their life expectancy.
Instead, in the realm of pensions policy, there is only one outcome that matters: the level of people’s retirement incomes.
The key test set for the Chancellor’s reforms now – and in future by historians – will be whether they result in higher incomes on average for DC savers. The counter-factual here is not just the current system, but also the reforms for the annuity market that the OFT, FCA and others had been feeling their way towards.
This is why the Government must release its modelling to show precisely how they think the Budget 2014 changes will increase the average retirement incomes of DC savers in future, and what the difference in incomes will be.
It is to be hoped such modelling exists. There is a wealth of research out there on the variable financial behaviour and financial capability of retirees, as well as an extensive academic literature on the so-called ‘annuity puzzle’, i.e. why is the prevalence of voluntary annuitisation so low?
But, worryingly, the evidence base on people’s financial behaviour deployed in the Treasury’s consultation document comprises a single chart showing a slightly higher ‘savings orientation’ among older people.
So, are DC savers likely to take their pension as cash, and accept paying their marginal tax rate on it (the £120bn question)?
Here it’s important to remember only around 15 per cent of UK pensioners pay income tax, and under the new rules, the cash can be drawn down in stages.
So, given the size of pension pots – the mean is around £35,000 – it’s unlikely many will have to pay more than 20 per cent (basic rate) as their marginal tax rate on the cash. And the literature on the ‘annuity puzzle’ suggests that in the thinking of many consumers, they will weigh this one-off tax ‘loss’ against the ‘loss’ they would otherwise suffer if they annuitized and died a year later. On this view, the tax-hit will look the better option, and people will grab the cash (in stages).
At the other end of the scale, around 5 per cent of pensioners pay higher-rate income tax, and those expecting to be in this category will face a 40 per cent tax rate whether they take their money as cash or income, so many big pots will also likely be depleted.
The media has had lots of fun debating whether pensioners taking the cash will then splurge (I won’t mention the ‘L’ word). There are also significant concerns for house prices around what number will transfer their money into property – many already see buy-to-let as a better alternative to an annuity. In some ways it is, especially for your inheritors.
However, the real risk is not pensioners splurging, but the opposite scenario: lots of retirees taking the cash, putting their pots into liquid savings or investments, then being afraid to spend them down for fear of running out of money – precisely the dilemma that annuities are designed to solve.
On this scenario, average DC retirement income will likely go down and the reforms in Budget 2014 will rightly be judged a failure.
Some will say that people saving more in the accumulation phase given the increased flexibility of their pots will offset any lower retirement incomes for DC savers. However, there’s negligible evidence that liquidity in pension saving increases savings rates, even if people inevitably report they like flexibility.
Indeed, the Strategic Society Centre has now completed two major studies with the University of Essex examining determinants of workplace pension saving using the UK Wealth and Assets Survey. The key predictor of participation is the availability of employer contributions, as well as owning your home. And most people’s contribution levels are the result of scheme design, and employer and regulatory choices, not individual decisions.
So, putting aside all the talk of “control”, “responsibility” and “trusting people to make their own decisions”, it is really very difficult to see how the Budget announcement will pass the key test with which history will judge it.
Few would deny that the annuities market did not need reappraising and shaking up – a process that was already ongoing. However, the changes announced in the Budget are likely to lead to lower retirement incomes for DC savers, even before the effect of a smaller market on annuity rates is taken into consideration, with its implications for those who do annuitise.
It’s difficult not to conclude that Budget 2014 was a bad day for UK pension policy.
And now the century-old ‘annuities deal’ has been broken, its unlikely any Government will be ever be able to put it back together.
James Lloyd is director at the Strategic Society Centre