Prior to changes announced in the 2014 budget, most people in defined contribution (DC) arrangements bought annuities. The changes from 2015 offered greater flexibility in how people accessed their retirement funds, no longer forcing them to purchase annuities at historically low rates. Later, there were concerns that without advice, those using the new flexibilities might deplete their pots in a short period of time and become reliant on the State.
Two and a half years in, several reviews have taken place to assess changes in consumer behaviour. A review conducted by the Financial Conduct Authority (FCA) found that 72% of members’ accounts placed in drawdown belong to those under 65, most opting for lump sum payments rather than a regular income.
This highlights a possible issue that may arise in later years as people continue to access their money early, without securing a regular income. The effect of early retirement is twofold. Firstly, the pot is typically smaller than it would have been if the individual had continued to work until later. Secondly, the pot must last longer.
The report shows that over half the pots designated for drawdown have been fully withdrawn (90% of these pots were below £30,000) with more than half placed in alternative saving accounts. This might not seem like a bad idea but the FCA suggests that this decision has been made as there is a perceived lack of trust in pensions. People could potentially end up paying more tax and missing out on superior investment growth.
The main issues highlighted at this stage include: people accepting drawdown from their current provider without shopping around and an increasing number of funds being put into drawdown without advice. Before the freedoms, only 5% of funds were placed into drawdown without advice, but this has now increased to 30%. Those who put funds into drawdown must manage their own investments and withdrawal strategies. Poorly informed individuals may choose investments that do not match their attitude to risk and may not devise an appropriate drawdown strategy, so they may struggle to maintain a steady retirement income.
Another issue is insurers deciding to withdraw from the annuity market as the lack of competition will weaken the annuity market (and therefore increase rates) over time.
Whilst it is too early to determine what the long-term effect of these freedoms might be, it is important to assess developing trends in consumer behaviour to protect long-term retirement outcomes. The government could consider introducing
a set of criteria to be satisfied before individuals can put funds into drawdown.
One option could be to force individuals to purchase a deferred annuity with a portion of their pot. This would provide guaranteed income and increase the demand for annuity products, thereby stimulating competition in the open market. The balance of the pot could then be designated for drawdown, subject to receiving financial advice. The government could also encourage the development of retirement products such as care home bonds in which people could pay premiums to an insurance company during their working life (perhaps by salary sacrifice), to secure a place in a retirement home at their later stage in life. Those opting for this option should be able to designate funds for drawdown once they receive the necessary advice.
These options allow the current flexibilities to be retained and go some way to preventing reliance on the State. Naturally, as DC pots grow and become the main source of retirement income, the market will be forced to develop by providing more retirement products to suit the changing needs of the population.
Sabrena Edmonds, Assistant Consultant at Quantum