The UK is hurtling down a regulatory path it may live to regret. Instead, we should try to learn from more developed DC markets around the globe
The UK pension system has gone through a period of cataclysmic change in the last decade – but is that change for the better? And what can we learn from other countries?
INCOME FOR LIFE
When George Osborne announced the ‘pensions freedoms’ it changed the fundamental nature of what saving for a pension meant in the UK. With savers no longer forced to buy an annuity a pension fund is no longer necessarily designed to provide a steady retirement income, but instead is all about ultimate choice for consumers.
This might seem a good thing but lessons from Australia and America are cause for concern. In Australia in particular, it is clear that too much flexibility has left the country with a real problem.
The country actually dropped from second to third place in the annual Mercer Melbourne Global Pensions Index (MMGPI), and one of the real areas of concern was the freedoms it offers consumers.
Part of the interim report of the Murray Review into the country’s financial system, noted that “around one-quarter of people with a superannuation balance at age 55 have depleted their balance by age 70”.
around one-quarter of people with a superannuation balance at age 55 have depleted their balance by age 70
If we see a similar pattern here in the UK, pensioners will face 20 more years of life with no private pensions income to fund them.
So what can we learn from this? The annuity market in the UK was clearly flawed, but what is emerging from the Australian market is that too much freedom can also be a bad thing. At a bare minimum it seems some sort of hybrid model is needed.
In Ireland, where savers can choose to buy an annuity or opt for drawdown, drawdown is the preferred option.
But only savers who can prove a guaranteed income of €12,700 from other sources can use drawdown. This makes sense – if you’ve got some sort of guaranteed income (for instance
a deferred annuity), why not use drawdown to access the rest of your pot.
WHO OWNS THE RISK?
The development of defined contribution has meant that all the risk is transferred squarely onto the already over-burdened shoulders of members.
And we found out last year that Steve Webb’s defined ambition proposals are off the table – at least for now.
It’s easy to see why. Ever increasing DB liabilities have left companies terrified of being responsible for their employees’ pension provision. But member risk creates a different set of problems for organisations and government alike.
If people do not have enough money to retire on – they will have to continue working longer, which limits the extent to which companies can manage their workforce and hire new talent.
And if they do retire at 67 they are likely to become over-reliant on the state – possibly for another 30 years.
Collective pension funds have been widely used throughout Europe as they generally reduce overall costs by achieving economies of scale, mitigate the risk that employers will have to fund any shortfall if investments perform badly and cushion the fund’s members, in general, against poorly performing investments and the additional cost of pensioners living longer.
And both the Netherlands and Canada have had some success with the model, although there have been some teething problems.
It’s not clear if the UK is ready yet for CDC, but it’s certainly something that could help with the rebalancing of risk between employers and members. And as companies are faced with more workers who want to retire but can’t afford to, demand could grow.
Even though defined ambition is off the table for now, The Pension Schemes Act 2015 received Royal Assent on 3rd March, 2015 and sets out the framework for collective DC schemes (referred to as schemes which provide collective benefits).
So the door is still open for employers who want to innovate.
HOW MUCH MONEY DO WE NEED TO RETIRE?
It’s not just the risk burden that causes problems for retirees; we also know that people aren’t saving nearly enough into their pots.
And the 8% contributions we’re heading towards won’t be enough either.
It’s a tricky problem – how do we get people saving more without spooking them into opting out?
David Blake, director of the Pensions Institute, believes auto-escalation is the answer. He notes in Pensions 2022: A vision of the future that: “The second strand of a ‘save more tomorrow’ plan is auto-escalation. The government accepted the first strand, auto enrolment, but chickened out of auto-escalation.
“Auto-escalation – the automatic increase in the contribution rate every year for three or four years – would in time provide the right level of contributions needed to produce a reasonable pension in retirement.”
Australia has had a lot of success in increasing contribution rates, but it does have a compulsory system.
In the UK, auto-escalation may be more problematic as savers are free to opt out if they believe that an increased rate of saving is unaffordable.
And for young people who are also grappling with sky-high rents and an out of control property market, the temptation to abandon pensions saving could be very strong.
Whether the UK should think about compulsion is a philosophical argument as much as it is a legislative one, but what is clear is unless we can find a way to increase contribution rates, savers will be looking at a pretty bleak retirement picture.
SLOW AND STEADY WINS THE RACE
The UK may be facing some pretty scary pensions issues. But we aren’t the first and we are not alone. When you look across the globe there are examples of great practice and also some giant red flags where things have gone wrong.
Pensions regulation in the UK is moving at a fast pace, with more changes coming through than the average person can keep up with. Perhaps it’s time for us to slow down and learn lessons from more sophisticated markets. That way, instead of following blindly in their footsteps, we can come up with a sustainable pensions system that works.
This article is part of a special report on Retirement Income, sponsored by State Street Global Advisors
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