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James Lloyd: Why I think the Budget was a bad day for pensions policy

The new pensions flexibility outlined last week by George Osborne has been praised by many advisers and other contributors to the Money Marketing website. Here James Lloyd sets out an opposing view. 

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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

Click here for all our Budget news and analysis 

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Comments

There are 8 comments at the moment, we would love to hear your opinion too.

  1. “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.”

    Do you really think it exists?

  2. The news here is brilliant in my view but read on. Over the last few years I/we have been doing all I can to dissuade people from buying awful annuities if they had other assets they could plunder instead. Sadly however, sometimes ‘vulnerability drag’ on advisers forced such a proposal to avoid losing even more by having yet lower future annuity rates and fewer years’ pension to enjoy! However, it also means:-

    1. That you should prioritise investing in a pension to avoid Income Tax at your highest marginal rate and if you pay tax at 45%, do the most you can before 5 April. Why? Because you will be able to access all your money without constraint and meantime it grows free from tax too. If you are over age 55 already, instant access is yours so put as much in as you can. Within the pension pot it can be held as ‘cash’ too if desired (even if very unwise for anything other than the very short-term). There are limits on what you can pay-in every year too and these are falling so if you earn significant sums from your work and have capital, optimise your allowances whilst you can.
    2. Just because you can take all the money out – DON’T TOUCH IT. Leave it in a pension which is now just a brilliant, tax-free investment wrapper but have it more responsively managed by a firm like ourselves (just up our street!). Knowledge that you can access it is better than taking it and invoking tax penalties and meaning you pay tax on all the returns from reinvesting it ‘outside’ the pension pot. Die early and 100% can pass over to a dependant or children, etc, free from Inheritance Tax too. Need an income? Forget annuities when interest rates are so low but just take a regular monthly payment – 25% is tax free and 75% subject to tax. It’s still income to pay your bills but you’re in charge! Check the figures and take a sum which keeps your tax bill as low as possible.

    We see an explosion in pension investing and people doing better things with their pension investments. Whatever they do, as long as they don’t take the money and buy a residential investment property…. once you take the money out of a pension, you can’t put it back in either other than within the existing rules. Even non-workers and the retired (with an age limit for now but watch that space too) can pay £2,880 into a pension and the taxman will give you 25% on top for free regardless of whether you pay tax too!

    Maybe if annuities had been manged as giant, diversified, perpetual investment funds rather than baskets of liabilities needing ‘guaranteed’ products to meet actuaries calculations we shouldn’t have needed this sort of action as annuities would have been paying double their ‘present’ rates…. but who would have taken that risk in the face of a compensation culture?

  3. @Philip Milton – Great minds think alike (must be in the first name 🙂 )

  4. I think it’s something of a curates egg – good in parts for those who are sensible and can either afford sound advice or have the time and skills to research, debatable for others who will splash the cash, and potentially stacked to the rafters with unforseen consequences.

    What it does clearly suggest though is that there’s even less reliability on the consistency of pension planning…..given the revolution one way, what’s to stop another government following the same principle and overturning the entire thing. For example all that cash yet to be stuffed away in the belief that it will be a great wheeze for IHT planning……suddenly locked up again…..(sudden shiver…I can feel that ambulance chaser peering over my shoulder……)

    Curious how times change – ten years ago firms were being heavily fined for “pension unlocking” – now it’s being hailed by HMG as the way forward. Perhaps those firms previously fined should ask for a refund……

  5. We’d better watch out Philip – agreeing on too many things… you must be as contrarian as me!

  6. I agree with most of the above comments, the changes have the ability to be great for those willing (or able) to find good advice about how best to maximise the income from their pensions (basically the budget was a win for the advice sector but thats another comment).

    The problem is going to be with those who do not wish to or can not find good financial advice. For many years government meddling and scandals have turned pensions into a dirty word for a lot of the public, the question is: do these new rules give confidence back to the public regarding pensions or does it allow them an opportunity to grab the money and stick it under the mattress?

    I would argue that the new rules have created more of a risk for clients. Know what your doing or find someone that does and you could be better off, don’t and you run the risk of making a mistake and not having enough retirement income.

    There is still the “subject to a consultation” caveat on the budgets headline change, lets wait to see what the result of that consultation is before deciding whether the government has made things better or worse.

    Thats my humble opinion anyway.

  7. All i know is since the budget, i have put an extra 2k into my pension. The extra flexibility makes all the difference.

  8. The new rules post April 2015 will make the “man in the street” much more likely to invest in pensions than before, but this is still not that likely! Until there is a realisation that retirement lasts a lot longer than 40 years ago, and until there is a realisation that long-term care costs are burgeoning with every year, then we as a nation will not save enough. As most comments have alluded to, the good thing about the Budget proposals is that those who are prepared to save will now have much more flexibility about how they take their pension pots. It will be interesting to see by how much the tax charge on crystallised pension pots on death (currently 55%) will be reduced, for if it falls to at or around the same amount as Inheritance Tax (40%) then pensions will suddenly become much more popular than ISAs. Or at least they should do for older people. My concern is that flexibility comes with the responsibility to make sensible withdrawals to ensure that a pension pot lasts a lifetime. Annuities are not dead in the water at all, as for those who simply do not wish to continue taking investment risk annuities still remain the right answer. I wish that instead of focussing on blowing up the concept of annuities, there was instead a facility to pass on an element of the annuity pot to heirs. Clearly this would lead to a reduction in annuity rates but if annuitants could “capital protect” their pension annuities for people other than their dependant spouse/partner/children then annuities would still be a good option for the risk averse.

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