Annuity reform: the rabbit in the Chancellor’s hat

Jonathan Galbraith on why Osborne’s big Budget idea on annuity reform should be welcomed.

Economy & TaxThe big surprise in George Osborne’s Budget last week —the proverbial rabbit in the Chancellor’s hat—is the change in pensions rules which will remove the requirement to purchase an annuity at retirement from April 2015 onwards.  An annuity is an insurance product that allows you to use your accumulated pension pot to purchase an income for life, thereby giving you protection against ‘longevity risk’: the risk that you will live longer than expected, and would otherwise run out of money.

However, annuities are unpopular as they would not appear to offer good value for money to many of those coming up to retirement.  Suppose you are coming up to 65, and you have accumulated a pension pot of £100,000, and you are looking to purchase an annuity to give you a fixed income for the rest of your days.  How much would you expect to get per year?  Your pot would buy you just £6,037 of pension each year.  And if you want to retire at 60, want something that will keep pace with inflation, along with a 50% pension for your spouse when you die?  This figure falls to just £2,824 per year.  If these terms seem poor, that’s quite possibly because they are: annuity rates fell by 66% in the 22 years since November 1990. And unlike taking out a life insurance policy, there are no refunds available: you are stuck with an annuity for life on the terms secured at purchase.

Interestingly, as a brief aside, those more expensive pension terms—retirement at 60, inflation-linked in retirement and with the attaching spouse pension—are those historically offered by public sector schemes.  This means that were a State employee to retire on a pension of £20,000 a year, he would have had to accumulate a pot of over £700,000 were he to purchase this on the open market. A useful statistic to bear in mind when the subject of public sector pension reform comes up.

The removal of the compulsion to purchase such a product has led to some dire predictions on the future of the annuities market.  Legal & General—one of the big players—insist that the market could shrink by three-quarters, with the amount going into new annuities falling from £11.9bn to just £2.8bn.  Perhaps this is to be expected: being forced to buy a product tends to be good for business, and the converse is equally applicable.  But should we be concerned by Osborne’s relaxation of the rules?  Should we pay heed to the likes of Labour MP Tom Watson, who believes the reforms would “pull the rug out from underneath the pensions deal that protects individuals, families and the taxpayer alike”?

I believe not.  The Osborne reform is a bold move, doubtless driven more by politics than economics—it’s popular with the voters in a time when the public finances do not permit many giveaways—but it recognises a few truths that many acknowledge, including the Labour opposition.  The annuities market has acted as a disincentive to people’s saving in pensions, due to the fact that money is locked away and—a few exceptions aside—only a quarter of it can be taken as a cash sum.  Let’s consider why the reforms are a good idea:

Annuity providers will have to raise their game.  Since the pensions “auto enrolment” provisions went live in 2012, almost all UK employees are compelled to join a pension scheme provided by their employers, and pay 5% of salary into it.  Can it be fair that all of us, when we seek to retire, have to choose a product from a handful of insurers, regardless of whether we regard it as good value for money?  In making this change, Osborne has broken up a cosy little oligopoly that has existed between the insurers: with compulsion removed, they will have to work harder to attract our business.  Mrs Thatcher made a number of bold reforms in the 1980s to remove cartels and here Osborne is following in her footsteps.

Flexibility will make pensions saving more attractive.  At a stroke, one of the main disadvantages of using pensions vehicles—the form in which the funds can be taken—is removed, thereby encouraging people to save for a pension.  Coupled with the increase in the ISA limits from 1 July, the Chancellor is promoting a savings culture: a habit we would do well to re-learn in the UK after having spent the boom years on a debt-fuelled binge.

People are being treated like grown-ups.  For all the bluster from Mr Watson, and pensions minister Steve Webb’s possibly ill-judged remarks about Lamborghinis, it remains the case that if you save money in a pension fund, it’s your money and you should be able to access it as you see fit.  The fact that people find annuity rates poor value for money would suggest that they make a lower estimate of their future life expectancy than do the insurers, but it remains the case that we cannot know with any certainty how long the average 60 year old will live.  All we do know is how old people are when they die now, and no-one –not even an actuary—can be certain on how improvements in mortality will continue.  Giving people the information they need to make an informed decision—Osborne has set aside £20m to ensure that people get access to financial advice at retirement—and then letting them get on with it goes with the grain of trusting people, rather than the old Whitehall-knows-best attitude.

Annuities will remain the right answer for some, and those people can still take advantage of them.  For those who still wish the certainty of a fixed income for life, they will remain free to purchase an annuity: nothing in these reforms precludes this.  There will remain a market for this kind of protection and the Osborne reforms should lead to a better deal for the consumer.

All in all, this unexpected reform has certainly changed the terms of the debate—both in terms of personal finance and politically—and we should await future developments with interest.

Jonathan Galbraith is a Fellow of the Institute and Faculty of Actuaries and a member of the Conservative Party.  Born and educated in southern Scotland, he now lives in Warwickshire and works in the pensions industry.  He writes in a personal capacity.

Sources: with figures taken as at 18 March 2014

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