By: Ben Franklin, Head of Economics of Ageing, ILC-UK

The retirement income market has undergone profound changes due to “pension freedoms”. Since its introduction, the ILC-UK has been at the forefront of understanding the potential consumer risks and opportunities associated with the reform. In this special extended blog, Ben Franklin, Head of Economics of Ageing, takes stock of where we are and proposes further reform to embolden consumer freedom through embedding informed decision making at the point of retirement. He argues that a critical first step to achieving this aim will be default financial guidance.

Since “pension freedoms” were introduced, retirement income decisions have become more complex. From age 55 there are a greater number of options for using the pension pot including taking the pension as cash, keeping the fund invested and purchasing an annuity. Yet the nation’s financial capability remains low – there is a lack of basic financial literacy, while behavioural biases such as loss aversion and inertia create the perfect environment for financial mistakes.

Further complicating the landscape for effective decision making, is a world of low interest rates and investment returns – savings accounts and cash ISAs offer pitiful returns, while annuities continue to be perceived as poor value for money when compared with their pre-crisis performance. As we argued in our 2014 report, this is an environment ripe for scammers, and indeed there have been increased reports of retirees having lost all of their pension savings to fraudsters which has prompted government to seek a ban on pension cold calling (over £40 million has been lost and this is likely to be a significant underestimate). Meanwhile, a recent report for the FCA showed that an increasing number of people are entering income drawdown arrangements without taking financial advice or shopping around – 94% of non-advised drawdown sales were made to existing customers, whereas when advice is given the proportion of drawdown sales to existing customers dropped to just 35%. And as predicted, the numbers of people taking out an annuity – which provides insurance against longevity risk – has plummeted.

None of this should take away from the fact that pension freedoms has been popular, giving individuals the choice to use their hard earned savings as they wish. This is especially important for individuals who already have good DB pensions or who wanted to use their relatively modest DC pension wealth to make improvements to their home, pay down debts, help their grandchildren or simply use their pension to enjoy life in the short term while they remain in good health. It should be emphasised that there are good rational reasons why people have embraced the freedoms and why enforced annuitisation would have been absurd. Indeed, the FCA’s evidence shows that the vast majority of fully withdrawn pots are small – less than £30,000, while over 9 in 10 consumers who have made full withdrawals had other sources of retirement income.

While cashing in the pension pot might make sense for some, there remains a sizeable contingent who have a high level of wealth concentrated in DC schemes and who will need to use it for an income in retirement – what was once called a pension – but there is an increasing reluctance to use pension wealth for this very end. Moreover, this sizeable contingent who rely on DC wealth to fund retirement will grow over the coming years due to the death of final salary schemes and rise of the auto-enrolled. While the Exchequer might be excited by the prospect of additional tax revenues from people cashing in their pension pots, evidence from abroad points towards a worrying future of underconsumption in retirement – if individuals fail to annuitise, they will self-insure resulting in people saving rather than consuming in retirement thereby adding to our current economic malaise. There may be wins in the short term, but potential costs over the medium to longer term – both to individual consumer wellbeing and to the Treasury’s coffers.

There is a burning need for policy pragmatism in order to embolden the principal of freedom and protect the consumer. Consider the following question – is freedom best served by individuals making knee-jerk decisions based on imperfect information, or is it best served by individuals making a long-term plan based on accurate information and advice? Now clearly not everyone will be making knee-jerk decisions and some may have sound information about their options, but evidence suggests a sizable proportion of people fail to make retirement plans, know how much money they will need to live off during retirement and underestimate their life expectancy. If we are asking people to make big financial decisions that could have long term impacts, it is critical we equip them with the right level of support to make those decisions, to understand the implicit trade-offs and opportunity costs of certain actions. And at the very least, we must avoid what most people would consider the worst outcomes, such as taking all of the money out of the pension and into a low interest bank account, or worst of all, being defrauded by a con artist.

The analogy of buying a house with a mortgage is a useful one. Taking out a mortgage is a complex process which requires us to consider our current and likely future financial position, the nature of our work as well as our evolving family circumstances in order to ensure we can repay. But human nature dictates that we don’t want to think about long run affordability, instead preferring to think about how we can best keep up with the Jones’ – “my mate Dave has a four bed house with a hot tub and swimming pool so I need to find the easiest way of getting that now”. Such behaviours were a critical factor in the run up to the financial crisis, brilliantly portrayed by Steve Carrell’s conversation with a highly leveraged stripper in the Big Short. Since the crisis, the UK regulator has delivered the Mortgage Market Review, which requires prospective borrowers to speak to a regulated mortgage advisor before a loan can be issued. Such activity is compulsory for most borrowers because of the risks attached to rash decision making, which were so brutally brought into focus in 2007 and 2008.

While mortgage advice is largely compulsory, at the point of accessing our pension pot we are on our own. Financial Guidance – whereby an individual can have a conversation about their options with a knowledgeable and independent professional – has been available since day one of pension freedoms, but take up rates remain low – estimated to be between 7 and 17% of eligible customers on the verge of retirement. Meanwhile, financial advice continues to remain the preserve of the few rather than the many. Both are a great shame. Emerging evidence on customer perceptions of the guidance service suggests the user experience has been good and people have taken positive actions (such as calculating income needed in retirement). Similarly, our recent research into the value of financial advice shows that those who receive advice accumulate more financial assets and pension savings than similar individuals who don’t receive advice, are more likely to save, invest in equity assets and attain higher retirement incomes. Those providing guidance and those in the financial advice profession believe that their services could be provided to many more individuals than is currently the case – the problem is arguably not on the supply side, it’s getting more people through the door in the first place.

Source: Pension Wise Service Evaluation and the Pensions Policy Institute

To get more people through the door requires policy intervention now. We cannot hope to create a perfect retirement income market overnight, but we can put in place an additional layer of consumer protection in order to support more informed retirement decisions and reduce the likelihood of costly human errors. One approach which is gaining momentum amongst industry and charity groups is to make financial guidance a default option when people try to access their pension funds. This would not be compulsory – people could opt out and go it alone if they wished – but rather act to nudge them towards guidance, which after all, is a free and impartial service paid for by the industry and not out of taxpayers’ pockets. While there is a case for having guidance at other key points in the life cycle, the need to have it at the point of retirement is perhaps the most compelling for quite pragmatic reasons. Guidance providers are already providing such support, so it would merely be an extension of their services. Meanwhile having default guidance earlier in the lifecycle but not at the point of retirement would potentially miss the crunch moment – the final backstop when people are about to make an irreversible decision that could have disastrous consequences for their long run wellbeing. In time, some sort of default lifecycle guidance service might be appropriate, but there is a more pressing need to establish additional protection today for those about to access their pension savings.

As the Work and Pensions Committee concluded:

“…whether improvements in the quality and take-up of guidance and advice can be achieved will be central to the success of the policy. It is right that people should be able to choose what to do with their retirement savings. However, freedom to choose is not enough; people must have freedom to make informed choices.”

As with any new policy measure, the benefits of default guidance – both economic and political – must outweigh the costs. So what are the potential costs of such a proposal? Below is a hypothetical list:

• Customers might decide to take advice and pick the first person they Google who may not actually be a regulated financial adviser.
• People may become overconfident in making DIY decisions and make costly financial mistakes.
• The disengaged may benefit less than those who happily take-up the guidance offer today.
• There are reputational/political risks of being seen to construct additional barriers to consumers wanting to take their pension pot money today.

In my view, many of these potential risks are largely overblown and critically can be negated by excellent guidance providers. Having seen the work of TPAS first hand, I have every confidence that they support better outcomes for their customers, enabling them to avoid the worst decisions. The preliminary survey evidence referred to above also points in this direction. The biggest perceived risk may well be political – putting an additional step in place before accessing pension funds could appear to go against the principal of freedom and choice. But it doesn’t have to be framed in this way. Rather it is a measure for ensuring that the customer gets what she/he wants – equipping them with the information and support necessary to make informed decisions in their long run financial interest. It is emboldening freedom rather than weakening it.

Default guidance is no silver bullet. Low levels of financial literacy and behavioural biases may prevent people from achieving optimal outcomes. But default guidance may induce positive behavioural responses – nudging people into action that they would not have otherwise taken. Of course it would be much better if people were engaged earlier in the process, but they’re not. For this reason default guidance would be a good start in terms of ensuring people get decent outcomes for the next 20 to 30 years.

In the long run, earlier financial engagement and good defaults for the permanently disengaged will also be important pieces of the puzzle. But we are a little way away from either of these at the moment. For these reasons, adding default guidance to the current pension system provides an extra layer of protection, emboldening rather than weakening the principles on which pension freedoms was built.