By Professor Charles Sutcliffe, ICMA Centre
The Chancellor of the Exchequer has announced that from April 2015 members of defined contribution pension schemes will be permitted to take their entire pension pot as a lump sum anytime from the age of 55 onwards. This means that defined contribution schemes will effectively cease to be pension schemes and become tax-sheltered savings vehicles. At present, at least 75% of the pension pot must be used to buy an annuity before the age of 75 (although a small number of rich people can enter drawdown). Currently up to 25% of the pension pot can be taken as a tax-free lump sum, and the evidence is that the vast majority of people opt to take the maximum lump sum.
The great unknown is what pensioners will decide to do when they can take their entire pot as a lump sum (with tax at their marginal rate on any amount over 25% of the pot). Will they take their pot as a lump sum, or will they use most of it to buy an annuity? If they decide on a lump sum, will they use the cash to invest in real or financial assets, or will they just consume the money, possibly becoming a burden on the welfare state in their later years?
Currently the UK is the largest market for annuities in the world, with about 400,000 annuities sold every year, and this number would have risen substantially with the introduction of auto enrolment. In countries where annuitization is voluntary, e.g. the USA and Australia, the annuitization rate is very low, and it is quite possible that making annuitization voluntary in the UK will mean that UK annuitization rates plummet to similarly low levels.
Economic theory is clear – for all consumers very substantial annuitization of wealth is preferable to non-annuitization, e.g. investing the pot in financial assets. This is primarily due to the mortality discount received by annuitants, where those who die unexpectedly early cross-subsidise the annuities of those who die unexpectedly late. In essence there is longevity risk sharing, which leads to higher pensions. In addition, an annuity removes the risk of outliving one’s resources and becoming a burden on the welfare state. There is no need to hold a precautionary balance of unconsumed resources as a hedge against living for an unexpectedly long time. However, while substantial annuitization is economically rational, the global evidence is that very few people choose to voluntarily annuitise a substantial part of their wealth. This is known as the annuity puzzle.
The benefit of the mortality discount for those who buy annuities means that the annual pension received by annuitants is substantially higher than the annual income of those who invest their pension pot in fixed income securities. Of course, those who invest in equities may be able to obtain a better return than that available on fixed income investments. But this is a risky outcome which may still be inferior to the income generated by the corresponding annuity due to the size of the mortality discount and because investors may end up paying high charges.
Those who opt to invest their pension pot in financial securities (i.e. self-annuitize) will be offered new products created specially by the financial services industry. However, the current drawdown market available to those who do not immediately annuitize their pension pot has high charges (e.g. 2% per year), and if similar charges are made for these new products, this will substantially reduce or eliminate any extra returns that may be achieved by investing in such products.
Given the choice, it is likely that many people will decide not to annuitize. Some people will just consume their pension pot and have no occupational pension. Those who decide to self-annuitise will probably receive a lower income in retirement than those who choose to buy an annuity because they will not benefit from the mortality discount, will pay high investment charges and may make unwise investments.
Therefore, despite the apparent attractions of allowing everyone to have access to their pension pot on retirement, those who choose not to buy an annuity will have a lower income in retirement. Although voluntary annuitization will generate higher tax receipts for the Chancellor over the next few years of about £3 billion, and lead to an increase in consumer spending; in the long run it will make many members of defined contribution schemes worse off.
Voluntary annuitization for defined contribution schemes also has implications for defined benefit schemes. Currently the members of defined benefit schemes can take up to 25% as a tax-free lump sum on retirement, and receive what is in effect an annuity. Some schemes may incentivise members to transfer their accrued defined benefit pension into a defined contribution scheme, with the attraction of a 100% lump sum on retirement. If widespread, such behaviour would further erode the position of defined benefit schemes.
There may be some additional adverse consequences of this reform. For example, a sharp drop in the annual annuity sales of £12 billion would lead to a corresponding drop in demand for government and corporate bonds, leading to a rise in interest rates and a deterioration in the quality of the annuity market.