No one should be in any doubt: this year’s budget was an historic day for UK pensions policy.
Since the Finance Act of 1921, UK pensions policy has had as its foundation stone the ‘annuities deal’: in return for exceptionally generous tax relief, pension savings must be converted into a secure pension income at retirement, which means an income that pays out until the end of your life, whenever that occurs.
For ‘defined-contribution’ pension savings, the ‘annuities deal’ was policed by ‘punitive’ tax charges (55 per cent) levied if savers wanted to cash-in their defined contribution pension pot.
However, without any warning or debate, Budget 2014 saw the chancellor tear up the annuities deal, announcing that defined-contribution pension savers would be able to withdraw all their pension savings from the age of 55, with only the application of marginal tax rates being charged as a disincentive.
Since the budget, debate has been uncomfortably heated and political for pensions policy, where historically stakeholders have trumpeted the importance of discussion and consensus building, particularly across political parties.
In places, this debate has been focused on whether people should be ‘trusted’ with their own money.
However, from the point of view of pensions policy, there is one test and one only that actually matters: will the changes in this year’s budget result in higher average incomes for defined-contribution pension savers?
All the evidence suggests not, and history will most likely therefore judge this policy a failure. Here’s why:
The reason the annuities deal existed for so long is that most people don’t like pooling ‘longevity risk’, for example, by buying an annuity. It means handing over your savings but accepting that you may be someone that dies earlier than average – thus taking the risk that you won’t get all your money back. So, for nearly a century, UK pensions policy has been built around compulsory annuitisation: if you want the benefits of pension saving, you have to commit to pooling longevity risk.
The unpopularity of annuities means that the prevalence of voluntary annuitisation around the world is very low. In fact, there is an entire academic literature on the so-called ‘annuity puzzle’: why do so few people opt to purchase annuities and smooth their income over their life course, even though it is the economically rational thing to do?
So, if people do not buy annuities following the budget announcement, what will they do?
Some will, as widely tipped, seek out the best alternative to buying an annuity, which in the UK means investing in property and buy-to-let. This will have potentially negative consequences for the housing market and the prospects for first-time buyers.
However, most will probably take the cash and leave it in a savings account or investment product. At that point, rather than splurge the cash – as has been suggested in the media – most are likely to be afraid to spend much of it for fear of running out. That’s because they do not know how long they will live for, ie. precisely the dilemma that annuities are designed to solve.
In this way, over the course of someone’s retirement, people are likely to have lower retirement incomes because of the changes announced in the 2014 budget.
In addition, within the residual annuities market, it is widely expected that the smaller size of the market will increase marginal overheads and reduce the typical income level paid by annuities. This is why some favour retaining the existing annuities deal, but building on proposals by the Office of Fair Trading and others for improving value for money in the annuities market.
It’s been fascinating to watch political and media debate frame pensions policy in terms of trusting the individual, and giving people control. However, in pensions policy this is not the test that matters, and will not be how history judges the Chancellor’s historic announcement.
James Lloyd is Director of the Strategic Society Centre.