Most of the comment about the Government’s plans to create ‘freedom and choice in pensions’ has focused on what people will do as a result of the changes. Will we cash out our defined contribution pensions and buy sportscars? Will we throw ourselves at the mercy of the state when all our money is spent?
I’m not convinced by those who portend doom. While we tend to underestimate how long we will live, the margin is small. And any extra money withdrawn from pension pots will be taxed as income, reducing the temptation to suck the money out and splurge.
But let’s think about it from the other end: what happens to the pool of capital that we accumulate in our pensions? At the moment, 75% of those of us in defined contribution schemes purchase an annuity when we retire. By the estimates quoted in the Treasury’s consultation document that tots up to £210bn in annuity buying so far and an extra £11bn a year. Perhaps as much as £150bn of this money has been used by annuity providers to buy corporate bonds and around 60% of the annual flow of £11bn goes the same way. Some of the remainder goes into infrastructure projects. That’s all investment to fund growth, delivering a fixed return which is what provides the annuity holder with a regular income.
Critically, after a pension pot has been annuitised, we can’t change our mind about what to do with it. That’s the problem the government’s reforms are trying to fix. But the other side of the coin is that the inflexibility is exactly what enables the money to be put to use for long-term investment.
If the numbers of us purchasing annuities halves, let’s say, when the new freedoms kick in, then that’s a drop of perhaps £5bn in the annual demand for corporate bonds. That is as much as a quarter of the net issuance in high-grade UK bonds, hardly a trivial fall in demand. Now some of us might replace annuities with alternative investments, the money from which ends up in corporate bonds by another route. But we don’t know how much of that will happen. On the whole, we would probably want investment products that provide a bit more flexibility than an annuity. So there will be something of a direct hit to long-term investment.
There may also be a direct hit to investment returns. The general rule with savings is that the more flexibility you have in how you access your money the lower your rate of return. We see that play out with savings accounts. Instant access on the whole means you get a lower interest rate than if you have to give notice before you take out your money. So while there might be a lot of dissatisfaction with the low rates paid by annuities right now, the dissatisfaction with returns from future alternative investments might be all the greater.
I just can’t see what other magic we will be able to work by investing our pensions in other ways: shorter time horizons mean lower returns, unless risk is being increased; and when risk is increased there is a greater diversity of possible outcomes. In other words, either we leave our money in the equivalent of an instant access high street savings account instead of buying an annuity, so we have complete flexibility but a low rate of return. Or we invest in something that is a bit riskier, aiming for a higher rate of return, but we might not succeed in getting it.
All of which suggests that in the end a lot of us might want to keep buying annuities. So why are we talking about this? The reason is that the turn back to annuities might take a bit of time – and what happens during that time. Immediate forecasts are that the proportion of people wanting an annuity will drop to 10-30% when the reforms are made. That’s a significant contraction in the market. Some of the companies currently offering annuities will do it no more when demand falls in that way. Those who continue will struggle with pricing. They’ll be investing less money and have a smaller base of annuity holders across whom to spread their risk. They might be left with the people who are likely to live the longest.
All of these factors might mean that the return on annuities is driven down; and that in turn might mean that the proportion of people tending to buy an annuity drops even further. More providers exit the market; pricing becomes even less competitive.
Luckily (though hold your judgement on the luck of this for just a minute), the government will soon be offering an annuity-like product for those of us who want to buy it. This is in the form of a top-up to the state pension.
From October 2015, a 65 year old for example can buy an extra £52 per year of state pension for life in exchange for a lump sum of £890. This is already highly competitive with annuities available in the market and could very well become the market-leading purchase. On current plans, the maximum amount of extra pension we can buy is £1,300 per year and the offer is limited to those soon reaching the state pension age.
But imagine this: an annuity desert, in which there are few other providers, and they can’t match the rates being paid by the government. The pressure for government to widen access to its offer, upwards in terms of amount and outwards in terms of who can buy in, will be massive, especially if a wave of pensioners has just seen the value of their pensions savings eroded in low-return investment options or their savings lost entirely in higher risk ventures.
If government succumbs to such pressure – and it has form on that, witness the announcement of special pensioners’ bonds in the Budget last week – then the net result of what I’ve been describing will be that our pensions’ money will fly out of long-term investment – in the form of annuity purchases – into the Exchequer – in the form of buying state pension top-ups, perhaps to the tune of several billion pounds per year.
Growing the size of the state would be a strange result to end up with from a set of reforms designed to increase freedom and choice in pensions; and it would be a dangerous sort of growth as well, with longer lives increasing costs ever more for government, and less investment going into the rest of the economy to create the revenues that fund government spending.
Will this happen? I don’t know. I doubt anyone does. But the possibility suggests that we need to think just as much about the other end of the pensions question – where do our funds go at the moment and where do we want them to go in the future?