Most members don’t have the necessary specialist knowledge to make the best decisions about their savings, argues Dr David Blake, professor of pension economics at Cass Business School
The pensions freedom and choice reforms now enable individuals to give up a guaranteed income for life in favour of more flexibility. But in doing so, the reforms have introduced associated risks that which many people don’t fully appreciate.
One of the most obvious is longevity risk. In a defined benefit (DB) scheme, that risk is borne by the scheme – and if you buy an annuity, it is managed by the insurer.
However, if someone withdraws their pot as cash or doesn’t invest it effectively, that risk is passed onto the individual. The chances of dying before you are 65 are less than 1% - but the probability of living longer than you expect is over 50%. That is not sufficiently appreciated at present.
The probability of living longer than you expect is over 50%”
We must also take the behavioural issue of immediate gratification (i.e. the ability to access money immediately) versus deferred gratification (i.e. a pension in the future). Immediate gratification is hard-coded into our DNA, whereas the patience required for retirement planning must be acquired.
If you don’t have a savings habit from early life, it is hard to introduce at a later stage.
Pots can deplete with terrifying rapidity if the funds in them are not appropriately managed, and there is generally no way for individuals to increase their wealth once they have left the workforce. As people get older, their mental capacity may also be reduced, making financial decision-making harder.
To respond to these concerns, the pensions industry needs a default retirement solution. The complexities involved in getting people to pay in 2% or 3% under auto-enrolment are trivial in comparison to the choices involved at retirement.
Not only do these require an appreciation of longevity risk, they need to take several other risks into account.
Pots can deplete with terrifying rapidity if funds are not appropriately managed”
Inflation has been low for a long time, for example, but we can’t rule out a spike in the future. Investment risk is another concern for those who manage their own portfolio.
Pension scams are rife, and there is also the additional risk that individuals don’t or can’t take appropriate advice when deciding how to use their savings.
However, a default retirement strategy could address these risks. The Independent Review of Retirement Income, released in March 2016, recommended a retirement income plan, using a simple decision tree with limited options for members including annuities, drawdown and longevity insurance, aimed at pension savers with between £30,000 and £100,000 in assets.
The retirement plan process would start with a guidance or advice surgery. From there a member could choose from a set of ‘safe harbour’ products approved by a regulator that demonstrate they provide value for money. An individual with a plan would be able to have flexible access to their pot until the point at which the longevity insurance starts.
The income that an individual will need in retirement is neither consistent, nor is it certain. And, in practice, there is no totally safe annual withdrawal rate.
Those uncertainties, coupled with the limited financial understanding that many defined contribution (DC) savers will have, mean that a ‘default’ solution for retirement savings should now be a matter of priority.