In this edition of Informed Comment, Baker Tilly's Mark Wilson looks at the factors in achieving good-value annuities, and whether employers are doing enough to help staff.
Employers, and employees, invest a huge amount of money and time into funding and implementing these schemes and communicating the benefits of pension savings.
Yet often, neither side does enough to ensure retirees get full value.
Three critical elements combine to ensure the scheme member gets a good annuity income: annual management charges, investment strategy design and execution, and finally the annuity itself.
How many retirees – or employers – really understand the impact of each of these elements? In this article, we will look at the impact of these on two hypothetical employees.
For the purposes of our example, both employees earn the national average salary of £26,200, contribute 10 per cent of that to their pension fund for 35 years and retire aged 65.
Many employees are losing out because the AMCs on their workplace scheme are not competitive.
According to the Office of Fair Trading, around a quarter of all contract-based and bundled trust assets are at risk of offering poor value for money.
The difference this makes can be substantial – a 0.5 per cent AMC for Employee A reduces the pot value by 11 per cent, but a 1 per cent AMC for Employee B reduces it by 21 per cent.
Investment strategy
Many employees lack the financial education to make good decisions about which pension fund to choose.
It is very common for employers to leave this aspect entirely to the employee
This can also be the case with employers. Lack of understanding can lead to employees making poor pension choices from lacklustre pension options. The impact of this can be dramatic.
Our case study assumes Employee A's pension pot grew annually by 7 per cent. This is an optimistic rate of return.
Employee A achieves this because he is supported in order to make good choices each year and his employer’s governance committee reviews the fund options regularly.
Employee B was given no financial education and his employer has poor scheme governance. He achieves 3 per cent a year.
At retirement, he would be £193,985 worse off, with £160,973 down to investment performance.
In many cases retirees will not understand the open market option, the fact that there are options around ill health or the difference it can make to their annuity income.
They will not be aware of the different types of annuity or features available.
The difference between the best and worst annuity rates available can be enormous, yet around half of all retirees simply accept the first deal they see.
Aside from reviewing the rates and options available from different providers, professional advisers can assess whether the retiree is eligible for an enhanced annuity.
The right rate
Employee A receives a pre-retirement counselling service including access to a specialist. He gets an enhanced annuity that reflects his health and lifestyle.
Employee B’s employer does not provide this service so he – like around half of all retirees – does not understand that the standard letter he receives from his provider is really only offering an illustrative rate, so he signs and returns the forms.
He gets a poor-standard annuity rate on his small pot, representing an annual income shortfall of £18,942 compared with Employee A, and misses out on potentially valuable features.
In our experience, it is often possible to improve on the first rate offered by 25 per cent or more, yet it is very common for employers to leave this aspect entirely to the employee.
This can undo the value added through good choices earlier in the pension process.
These two extreme examples clearly show the impact of getting any of the three elements wrong, and the potential cumulative impact.
The Department for Work and Pensions is clear that employers are being given increasing responsibility for delivering good retirement outcomes.
The Pensions Regulator already asks employers to maintain robust audit trails to demonstrate how they implemented their schemes.
We expect this to extend to demonstrating that the scheme provides ongoing value to members and that it ultimately delivers the right outcome.
Mark Wilson is head of employee benefit solutions at consultancy Baker Tilly
