If the Labour Party wins the 2015 election it will come to power 32 days into a revolution in pension policy that is set to leave British retirements permanently diminished. So the Opposition must use the next six months to prepare decisive plans to replace George Osborne’s pension reforms with its own alternative, to be implemented as part of next summer’s emergency budget.
The reforms contained in the forthcoming Taxation of Pensions Bill are wrong because they stop pensions being pensions. The whole point of the system is to provide secure income for retirement; but these changes put that to an end, by allowing people to take their entire pension as a lump sum and use it any way they want. For when George Osborne declared ‘it’s your money’ and that government should have no say over its use, he turned Defined Contribution pensions into mere savings accounts.
Before now politicians have always seen DC pensions as part of a strategic framework for retirement incomes, based on long-term policy objectives such as helping everyone to avoid poverty in retirement and replace a reasonable share of their previous earnings. Policy makers recognised that people are not very good at deferred gratification and designed benign constraints to help us spread money, consumption and wellbeing over the course of our lives. Government does this through the workings of the welfare state, but also by promoting and regulating private pensions.
This philosophy still informs the accumulation of pensions, as demonstrated by the current implementation of auto-enrolment and compulsory employer contributions. But now, with the Osborne reforms, the state is saying it has no view as to whether people should use their pension pot for its intended purpose of providing income in retirement.
When the pension reforms were announced, much was made of the risk that pensioners would blow their life savings on world cruises or Lamborghinis. But sadly, the reality is likely to be the reverse: many older people are risk averse and under-consume their savings, partly irrationally but also because of legitimate uncertainty regarding their life expectancy and the unforeseeable costs of late old age. Household surveys map this under-consumption with respect other classes of asset, so it is very likely to happen with pensions too. This reveals an ideological fault-line between economic libertarians and social democratic Fabians: George Osborne may be indifferent to markets being structured so that people hoard their assets and then live significantly impoverished lives. The left should not be.
But it gets worse, because pension pots aren’t actually ‘our money’ for the most part. More than half of the contributions to a typical DC pension come from employers and from the state in the shape of foregone taxation. So even if you accept that people should have complete freedom with respect to the fruits of their own contributions, there is no reason why this should apply to the contributions of employers and taxpayers. Why should the taxpayer spend tens of billions a year and not see government policy objectives achieved? And why should responsible employers encourage their employees to accept a pension in place of higher pay, if it is just to fund a savings account?
By undermining the annuity as a form of insurance, the reforms will also cost us all billions of pounds. Annuities are good for us individually not just because they provide a regular income, but also because they insure us against unexpectedly long lives. This leads to a cheaper system, because the costs of retirement incomes are shared across the population not borne individually: an early death helps pay for someone else’s late old age. So when longevity risks are not pooled through annuities, 15 per cent more needs to be spent to buy the same level of retirement income, according to a Deloitte study of the Australian system (on which Osborne modelled his reforms). That’s a big price tag for Conservative ideological purity and the passing pleasure of some 60-something voters.
So what should Labour do? The genie is out of the bottle so there’s no point pining after the status quo ante. In any case, the annuities market of recent years has been failing people badly, even though in principle annuities can be good value. The answer is to create managed choice, between lots of options that aim to provide long term security. This would mean permitting a range of regulated products, including well-established lifetime annuities and draw-down pensions, but also newer options like: time-limited annuities; annuities with higher payments triggered by disability; products to fund social care; and deferred annuities (these enable people to buy in their 60s a retirement income for their 80s and beyond, at an affordable price).
People should be able to choose between these products, singly or in combination, creating choice and space for innovation, but also boundaries. For example someone prepared to tolerate investment risk in early retirement but also wanting security at the end of life could choose a draw-down pension and a deferred annuity together.
Meanwhile tough regulation would be needed to prevent mis-selling or excessive charges with respect to approved products; for some in the insurance industry scent that the new pensions world offers opportunities for new, high profit products. Regulated pension products would also need to come with clear defaults that would push people toward their long-term interests. For example there could be annual upper and lower limits for withdrawal from a draw-down pension but also a pre-set default, calculated to provide the same amount annually well into late old age.
Regulations would also be needed to ensure that guidance and advice services asked people searching questions that forced them to carefully reflect on their needs and preferences. This would presumably steer most people away from products that privileged early retirement over late old age; or a couple’s income over the survivor’s. It would also direct people to under-used products like individually-underwritten annuities which deliver higher incomes to people who are likely to have a lower life expectancy. Where individuals (or couples) decided to disregard recommendations they might be forced to sign paperwork acknowledging the downsides of their chosen options, taking their stated lifestyle preferences into account.
But one form of choice must not be allowed: retirees should not be able to take most of their pension as a lump sum. Labour should state now that, if it comes to power, people will not be permitted to cash in the share of their pension fund which reflects the employers’ and taxpayers’ contributions. That should be the left’s response to ‘it’s our money’: Labour would only consider complete flexibility for the slice of a pension pot which represents people’s personal contributions. In practice this could simply mean just reverting to the 25 per cent tax-free lump sum (since this is worth around 30 to 40 per cent of the value of a fund, including the tax relief).
There is no going back to the future. But George Osborne’s pension revolution must be dismantled within weeks of Labour gaining power. Otherwise the rot will set in and people’s expectations about the rightful role of pensions will be swept away forever. So Labour’s offer must not be a choice between cash or a pension; but one of managed choice, between a range of credible and diverse retirement income products.
This article draws on the conclusions of a recent Fabian event, ‘Unlocking wealth to meet retirement needs: How should Labour respond to Osborne’s retirement revolution?’ kindly supported by Just Retirement.