Too much of a good thing

When it comes to planning for retirement, there are a few things we can count on. People do not always act rationally, they do not always act in their own interests, and very few have unlimited will power. As a result, decisions are usually made as a result of behavioural traits, and this commonly results in the easiest or most obvious option being chosen, even if it may not be the best available. Ironically, the more choice there is, and the greater the sophistication of those choices, the greater chance people avoid making a decision at all. 

Both The Pensions Regulator and the Personal Accounts Delivery Authority (PADA) have recently highlighted some of the issues surrounding members converting their pension into a retirement income. A recent ‘good practice' note issued by The Pensions Regulator, entitled Member Retirement Options, explained that trustees have certain duties and obligations to ensure good governance of the pension scheme. In particular, it highlighted that trustees must comply with the legal requirements, namely offering the open market option (OMO) and providing the required information around it. It also identified the need for trustees to understand their responsibilities in relation to the conversion of the member's money purchase account into a retirement income or an income for a dependent. In summary, schemes need to have a clear retirement process in place for their members.

In its discussion paper, Building personal accounts: securing a retirement income, PADA suggested that personal accounts will have no default option (except at 75), meaning that members will be forced into making a choice of annuity when they retire. The expectation is that most people will buy an annuity, rather than drawing down their pension, and that the OMO will be used as a result of there being no default. PADA suggests that a panel of annuity providers will be used. Those whose pension pots are big enough (£250,000+) and ‘drawn-down' will be effected by switching to a self-invested personal pension at retirement date. With independent advice unlikely to be provided, the internet will likely be the preferred medium in terms of guidance.

At present, an annuitant has several options. The most common form of annuity (a conventional annuity) is where the price is determined with reference to the individual's age, gender and postcode. Then there is an enhanced, or impaired life annuity where rates are uplifted due to the expectation that the individual, due to lifestyle or medical history, will have a shortened retirement. There are also investment linked (unit-linked or with profits) annuities that fluctuate according to bonus declared on the with-profits fund. Finally, a variable annuity is very similar to that of a unit-linked annuity in that the payments under it will vary over time. Some statistics based on ABI and Legal & General data quoted recently illustrated the pitifully small pots that are currently being tendered to purchase annuities: 78% of funds are less than £30,000, 69% of funds are less than £10,000 and the average fund is around £30,000.

As a result, the annuity market is having to change. There are some key drivers of this change, with longevity being one of the biggest. We are all living longer, which is not particularly good if you are an annuity provider. Using just age and gender to price annuities on a conventional basis is just not sophisticated enough any more. What is needed is a bottom up approach: taking the conventional annuity and adding further indicators to make them more targeted.

People's approach to retirement is changing: fewer are able to fully retire at ‘retirement date', due to financial circumstances, and there are people who are just not yet ready to retire fully. As a result, other options might need to be considered and developed. An individual might look at phasing retirement by switching their accumulated fund into segmented personal pensions. Through this approach, the member uses their pension pot and switches it into a number of consecutively maturing personal pensions that can be annuitised year after year, thus gradually increasing income as the amount of time spent at work reduces, until age 75 when an annuity must be purchased with any pension contracts remaining. 

Another alternative would be to use part of the members unsecured pension to purchase a short-term annuity (five years), to provide extra income, as the working hours are reduced, and leave the balance invested until such time as the member is in a position to annuitise fully. Both ideas get around the necessity to purchase an annuity at one point in time which, when annuity rates are at their lowest for decades and when people are looking to stay in employment longer, offers more flexibility to the member.

People discount the longer term disproportionately to how they discount the short term. They tend to bias a status quo, taking the easy option and viewing defaults as a form of endorsement. Therefore, we feel that a guidance process is essential and a member decision pack should be seen as an absolute must, to be issued in meeting the OMO requirements. A web based decision maker, perhaps incorporating a decision tree to guide members to the product that will be most appropriate to them or alternatively the use of an annuity-buying service should be considered, where experts can be called upon to guide the member through the process.