Annuities for the DC generation

In the pensions industry we spend a lot of time talking about how we can get more people saving more and how we can get them good returns so they can have a decent pot at retirement. But as more people retire with bigger defined contribution pots, and, as less people retire with a proportion of defined benefit, we are going to need to refocus on what ‘at retirement’ looks like. This is a clear focus for government, having launched a new consultation on decumulation.

An established, but poorly understood system

Knowing how to take your money in retirement used to be easy. People with the smallest pots took a small pot commutation, a few went into a complicated and restrictive form of drawdown, but the majority of those with any sizeable savings took their tax-free cash lump sum and had to purchase an annuity with the remainder. People had to decide on the type of annuity they wanted, eg, single-life escalating or joint-life flat, and also shop around for the best deal. And while this was tricky enough, at least people’s choices were tram lined by what the tax rules allowed. 

There were many problems with this system. People struggled to make a choice about the type of annuity they wanted and didn’t understand what was a complicated purchase. Equally, the shape of an annuity might not have met their needs. The system only really worked if people shopped around, and people understood their options. It was reliant on people to be engaged and active to get the best deal for them. And a ‘once and done’ annuity purchase, where people annuitise their whole pot on reaching retirement, was unlikely to fit most people’s circumstances – it was too constraining. The system was broken and needed fixing.

Unexpected and complicated consequences

It is fair to say that no-one expected what would happen next. The ripping up of the retirement rulebook in George Osbourne’s freedom and choice budget in 2014 turned pension saving and planning on its head, and we are still working through the consequences of this change. No longer would people have to purchase an annuity. Instead they had total freedom and choice as to how they manage their pensions savings. This hugely increased the complexity of retirement decision-making, but it also opened up an opportunity to develop solutions that better fitted with people’s needs. That’s an opportunity we are all still grappling with. 

So what does the future look like? Annuities are back in fashion with recent increases in rates, and that must be a good thing as we know that people do value guarantees and certainty. The security provided through annuities will be a valuable part of the retirement toolkit for people, but, for many pension savers, putting all their eggs in one basket or making one-off product purchases to secure income may not be the best way to go. 

A combination of moves

Increasingly, we think that people will use combined approaches to securing income, helping to balance out the need for certainty with the desire for flexibility. We think that we’ll increasingly see guaranteed portions of an income used to cover essential expenditure, with non-essential expenditure covered by drawdown. This allows people to balance out certainty and flexibility, ensuring they've got the basics covered while keeping a proportion of their money invested. Furthermore, securing the guaranteed portion of the income could be undertaken in stages, to take advantage of improving annuity rates as people get older. As well as giving people flexibility, this could also act as a good inflation hedge, which is particularly important in current times.

An evolving market

Our modelling suggests that this could lead to better outcomes for people, both in terms of financial outcomes, but also giving people flexibility to adapt their approach as their plans change. It obviously depends on people’s circumstances and a one-size fits all approach is unlikely to deliver the best outcomes for everyone. 

We believe that blended approaches will be the way forward as trustees and providers look to innovate in the ‘at retirement’ space. And as the pensions minister has made clear, government recognises that the DC decumulation market is still developing and evolving, and welcomes further innovation in the market to help provide the solutions to meet the issues we face. Solutions and approaches are evolving and developing, but where we really need to focus energy is on the choice architecture to help people with the decisions that they have to make. Access to advice is crucial here, but equally important is how we help and guide those that don’t access formal advice and what the potential role of default strategies could be to help anchor people’s decision-making in retirement.

No more cliff edge decisions

We also need to think of retirement decisions as ongoing. But, from what we know, people do like to set and forget so they don’t want to be making decisions on a yearly basis, but they do need flexibility to be able to adapt in a change of circumstances. This will be a key challenge, especially as people get older and potentially become more vulnerable. But if we don’t crack this, then we’ll never be able to really help people make the most of their pension savings. 

To deliver great outcomes we need to innovate. ‘Freedom and choice’ is all very well but it doesn’t on its own deliver what people want more than anything – an income. We have to accept that as an industry we bear a greater responsibility to come up with solutions to deliver a decent retirement.

Claire Altman is managing director for individual retirement at Standard Life