Freedom and choice in pensions

Transcription

1 Freedom and choice in pensions June 2014 Response to Budget Consultation This report is provided to our client solely for its use, for the specific purpose indicated. It may not be disclosed to any other party without evalue's prior written permission, except as may be required by law. No other party may rely on any advice contained in this report, and evalue does not accept any liability to any other party in respect of this report.

2 Table of contents Table of contents Executive summary Budget challenge Guidance Greater complexity for advisers Consumer communications Stochastic forecasting Simplified advice Response to the specific consultation questions... 13

3 1. Executive summary evalue welcomes the Government s proposal to liberalise the way in which pension savings can be accessed in retirement. The removal of most of the restrictions on how pension savings can be used will foster a sense of ownership and this should result in a greater willingness on the part of the public to save for retirement. Nevertheless with freedom comes the risk that some unwise decisions will be made resulting in hardship for more retirees in later life. The Government is relying on the provision of free impartial guidance to help consumers make sensible decisions. However there is ample evidence the financial education has a very limited effect. The consumers just do not have the knowledge, time, or mathematical skills needed to understand even simple financial products. As a result the work of behavioural economists and the use of gamification is increasingly being applied to engage and educate consumers. Predominantly guidance in the UK relies on the provision of information and, in the financial services industry, development has be hampered by the lack of clarity on the dividing line between guidance and highly regulated advice. It is hoped that the result of the FCA s thematic review will remove this ambiguity. Whatever the result, much ongoing work will be required to engage and educate consumers, so that informed decisions can be made by consumers on how use their retirement savings. evalue believes that competition is essential to improve the quality of guidance. This will be a continuing process of monitoring consumer responses and making incremental improvements to drive standards higher. Product providers should be allowed to provide guidance to their customers subject to safeguards including FCA standards and monitoring. Product providers should also be required to provide access to sources of impartial guidance and independent advice. evalue believes that most consumers would benefit from advice about the complex issues involved in providing a sustainable income in retirement. For most consumers, this will not be available at a price that can be afforded. It is therefore imperative that Simplified Advice is made available as a low cost option. This could be delivered online focused on a specific question e.g. whether a consumer should buy an annuity or use income drawdown to provide an income in retirement. To date the regulatory framework has discourage the provision of Simplified Advice. We urge the Government and the FCA to amend the legislative and regulatory environment so that low cost Simplified Advice can be made available to consumers.

4 2. Budget challenge The 2014 budget has removed virtually all the restrictions on the way in which a defined contribution pension can be accessed. Up until now, virtually everyone with a defined contribution pension had to buy an annuity which, while they have attracted criticism, at least ensured that consumers received an income for the rest of their lives. Freedom of choice is a good thing and any extension of it should be applauded. However there is a considerable risk that some very unwise decisions will be made which will come back to bite later in retirement. Retirees are a very vulnerable group who have little ability or time to repair the damage done by earlier bad decisions. The Government appears to laying much store by the requirement for impartial face to face guidance to be given. However, the size of the task should not be underestimated. With nearly 21 million DC pension plans and 8 million workers with DC pensions, and the numbers set to increase dramatically due to auto enrolment, technology is the only practical and cost effective means of delivery of this guidance. 2.1 Guidance A key question to be answered is whether product providers will be permitted to provide this impartial guidance. The arguments against are that product providers are prime facie not impartial. The FCA recently criticised product providers for the lack of attention drawn to the use of the open market option to purchase annuities on retirement. However product providers do communicate with their customers regularly so it seems odd that they would not be able to provide them with guidance from 55 onwards which is the critical period when pension benefits become available. It would also be at odds with objective of many product providers to improve their relationship with their customers by providing on-going communications and services. A sensible approach to the provision of impartial guidance would be: For the FCA to produce a comprehensive minimum template for the guidance to be provided; For the delivery of this guidance to be monitored by the FCA; For product providers to be allowed to provide the guidance with the proviso that customers are invited to access an source of impartial guidance from an independent third party or to talk to a designated independent adviser (or choice of independent advisers) if they wish to have free impartial guidance or pay for advice.

5 This approach would enable product providers to communicate in the usual way with their customers (subject to the guidance template) but also ensure that the customer can get independent and impartial guidance if they require it. For product providers, the cost of the referral to independent advisers is unlikely to be great as these referrals will create for adviser firms the opportunity to offer their advisory services. This approach would also ensure that consumers have easy access to advice if they need it. The following diagram shows how guidance and advice could be offered to consumers. A product provider could provide online guidance to consumers. This would ensure a consistent approach and would be easy for the FCA to monitor. One or more adviser firms, independent of the product provider, would be appointed who could offer impartial guidance if requested by the consumer. If consumers wish to receive advice, they can select an adviser (if more than one) and customer data would be released from the product provider s guidance software to the adviser s financial planning software. This would help to reduce the cost of advice. Costs could be further reduced for consumers by providing them with the option of entering additional information on their circumstances e.g. other retirement savings and on their objectives and aspirations in retirement. An online guidance system could offer consumers seeking to manage their retirement savings to provide an income for life, on-going access so that they could check on: o their chances to living to different ages; and

6 o the level of income that could draw to provide them with a sustainable income until a selected future age. The above approach should be cost effective for both the delivery of guidance and advice if required. However the number of advisers is limited and the cost of advice might still exceed what many consumers will find acceptable. For this reason, in section 2.5 we urge the Government and FCA to facilitate the delivery of online Simplified Advice. 2.2 Greater complexity for advisers In theory, the Budget is an enormous opportunity for financial advisers as they are well placed to meet the requirement for impartial guidance and many retirees will in fact need advice rather than simply guidance. However many advisers are ill prepared as relatively few have given advice on pensions income drawdown which overnight is likely to become the default choice for retirees. Risk will need to be thought about differently. Income sustainability will be the primary concern with the volatility of investments being of secondary importance. Annuities are the no risk option. The issues that advisers will need to address are: the retiree s objectives lifestyle choices; the initial income is required; the way in which future income is to vary; other sources of income e.g. State pension, non pension assets available; life expectancy; the overall level of income that is sustainable; how the pension fund is to be invested; the funds available on death for a spouse and other dependants; the associated risks i.e. investment, inflation, morbidity and longevity. whether the minimum income needed to survive be secured with an annuity or when should an annuity be purchased. An annuity will generally be appropriate for a no risk solution but alternatively a low income drawn down from relatively a large investment fund can be very low risk. As the consumer s appetite for risk increases, the solution could consist of a combination of annuity and income drawdown. The crucial point is that it is the size of the income drawn relative to the investment fund, as well as the downside risk of the fund, that determines the overall risk of income sustainability.

7 Drawdown will become the default solution from which income will be drawn (even if it is only tax free cash before retirement) and annuities and other products may be purchased subsequently at some future time. If the above is not enough complexity for advisers, substantial product innovation is expected with new products becoming available for retirement income such as: temporary annuities, specialist investment funds, short term structured products offering income and guarantees, variable annuities, and longevity insurance. These products in turn involve consideration of one or more of the following issues: cost and value of any guarantee; reinvestment i.e. at the end of the fixed term what impact will the investment markets have on future income; and sum available from the product on death. Very few advisers have experience of advising on drawdown as, to date, it has been a niche product with complex rules. From next April, drawdown accounts will become as ubiquitous as ISAs. Many retirees looking to provide themselves with income for life, nevertheless, have an aversion to annuities. They will need advice on the options available which will simply not be available due to limited capacity in the adviser market or they will not be prepared to pay the fees required from the relatively few advisers competent to advise them in this complex and high risk area. Simplified Advice is the answer for the mass market. 2.3 Consumer communications Without doubt the biggest challenge will be to communicate effectively the options available and the associated risks. Consumers generally have little understanding of their likely future life expectancy (normally underestimating its length) and the amount of capital required to support their desired level of retirement income. There is, therefore, a great risk that too high an income will be drawn in the early years of retirement and that pension capital will be reduced too rapidly to enable the initial income level to be sustained. Although the purchase of an annuity is the best way of addressing this

8 risk, annuities are not popular and have unfairly been criticised as expensive and poor value. Consumers also are keen that pension capital is available to a spouse or beneficiaries on premature death. For these reasons it is likely that many more consumers will opt for income drawdown. Ideally consumers would have access to advice not only at outset but also ongoing because regular reviews are necessary. However, a comparatively small number of advisers have the relevant experience and consumers with small pension funds are unlikely to be prepared to pay for advice. A substantial effort will therefore be required to raise the game with the communications made available to consumers. Learnings from behavioural economics and gamification will need to be applied in order to engage consumers and help them reach a point where they can make informed decisions. This is a substantial challenge in the 10 months remaining to April Stochastic forecasting Income drawdown involves uncertainty over the amount of income received and whether it will be sustainable for life. Given that these risks are durational, the only effective way in which the risk can be assessed, compared to the risk free option of an annuity, is to use a stochastic asset model to forecast the amounts of income from year to year and to compare the results with an annuity. A stochastic asset model produces thousands of simulations of plausible future investment market scenarios. Some examples of stochastic forecasts of the outcomes from income drawdown compared to an annuity are shown below. The green line shows the after tax income from an annuity. Two different displays show the forecast results. The first shows shading to represent the probability of the outcome the darkest area being the most likely. This diagram shows that there is an appreciable chance that income drawdown will give a worse outcome than an annuity, particularly before an annuity is purchased at age 75. The second diagram shows the same results using lines. While this presentation shows more clearly the downside, there is no guidance given about the probability of this outcome occurring.

9 The assessment of the value of guarantees, their cost and likely future reinvestment terms which will be involved with many of the new retirement income products can also only be done with the aid of a stochastic asset model. This enables advisers to see when a guarantee offers protection, the return given up by having the guarantee (i.e. its cost) and what investment markets may be like in the future when fixed term contract e.g. structured product or temporary annuity comes to an end. The following screenshots illustrate two alternative views of a variable annuity compared to a conventional annuity. From the stochastic forecasts, it can be seen that the variable annuity is initially lower than the conventional annuity and is guaranteed not to fall below this amount. It is also clear

10 that if the return on the variable annuity investment fund follows the median (average), it will take 10 years for the variable annuity to exceed the conventional annuity. From this type of a stochastic analysis, the adviser can make a recommendation and his client can make an informed decision about the options available.

11 2.5 Simplified advice If guidance is not likely to be sufficient to enable consumers to understand the issues and manage income drawdown during their retirement and advice is too expensive for most consumers, there is a dangerous void with considerable scope for poor decisions and outcomes. Many consumers, struggling with the choices available, are likely to opt for the easy option of cashing out their entire pension benefits. Simplified advice must be the way forward and has been proposed by the FCA as a means of delivering advice online. However, although simplified advice envisages a streamlined advice process, the risks and potential liabilities are the same as for full regulated advice. This, in effect, currently makes simplified advice very onerous to give. The FCA is currently undertaking a thematic review of direct to consumer offers on non-advised and simplified advice basis. It is hoped that the review will clarify where guidance ends and advice begins. Given the immense challenge of offering low cost advice to the large number of defined contribution pension holders reaching age 55 each year (in April 2015, the numbers will potentially be even

12 greater as all over 55s will be able to take advantage of the new options), it is important that regulatory environment is eased so that simplified advice becomes workable. A possible approach would be for the FCA to provide guidance on the type of hurdle questions which should be asked in order to determine whether advice focused on a particular issue, e.g. annuity vs. income drawdown, would be appropriate. If the hurdle questions identified that there were other issues which meant that simplified advice might be detrimental to the consumer, the recommendation would be that the consumer seeks full advice. Assuming that the hurdle questions establish that simplified advice would not be detrimental, an approach could be to use the answers to a series of psychometric questions (i.e. statistically tested) to point to a range of different retirement income solutions.

13 3. Response to the specific consultation questions A.1 The government welcomes views on its proposed approach to reforming the pensions tax framework. 1 Should a statutory override be put in place to ensure that pension scheme rules do not prevent individuals from taking advantage of increased flexibility? Answer: It is probable that a statutory override will be necessary as some pension scheme rules may inhibit pension scheme members from being able to benefit from the increased flexibility. For example, trustees of defined contribution schemes may feel that they have not appropriately discharged their obligations as trustees by paying out a member s pension benefits as a cash lump sum. Many trustees will not wish to administer pension income drawdown accounts with the potential exposure if things go wrong for the retiree. Many may therefore wish to transfer a member s fund to a suitable product provider, scheme rules many not permit this. Finally trustees may be concerned about claims from third parties (spouses and dependants) who may be disadvantaged by the decisions of members. 2 How could the government design the new system such that it enables innovation in the retirement income market? Answer: Product innovation will almost certainly occur but there is a considerable risk that the evaluation of the relative merits of these products may be difficult for consumers without access to advice. It is therefore important that access to independent advisers is made as efficient and easy as possible. We strongly believe that there should be competition in the delivery of guidance and that independent advisers are well placed to supply free guidance and in this way access to advice facilitated. Competition in the delivery of guidance is key and will also stimulate innovation. Engaging consumers will be challenging and it will be important to monitor consumer responses and to adopt processes of continuous improvement including applying learnings from behavioural economics and gamification. Without competition we do not think that the highest standards of communication and consumer engagement will be achieved. 3 Do you agree that the age at which private pension wealth can be accessed should rise alongside the State Pension age?

14 Answer: Yes there is a strong case that with increased longevity the age of access to pension funds should rise. 4 Should the change in the minimum pension age be applied to all pension schemes which qualify for tax relief? Answer: Yes 5 Should the minimum pension age be increased further, for example so that it is five years below State Pension age? Answer: Yes otherwise pension funds will be used to fill the large income gap between retirement and eligibility for a State Pension with the result that little of the pension fund will remain when state Pension Age is achieved. It is also undesirable for the UK economy to encourage people to leave the workforce by enabling access pension savings at an early age. A.2 The government welcomes views on its proposed approach to supporting consumers in making retirement choices. Answer: Face to face guidance is impractical given the number consumers with defined contribution pension plans. Technology must be deployed to help solve this issue (online and telephony solutions should be encouraged). Competition in the delivery of guidance is essential in order to achieve the highest standards of consumer engagement. Stochastic modelling is uniquely capable of helping consumers understand the implications of not buying an annuity. Our views are set out more fully in Section 2 of this document. 6 Is the prescription of standards enough to ensure the impartiality of guidance delivered by the pension provider? Should pension providers be required to outsource delivery of independent guidance to a trusted third party? Answer: Our views are set out fully in Section 2.1. In summary, we think product providers should be allowed to provide guidance but be required to promote prominently access to independent guidance. We believe independent advisers are well placed to offer independent and impartial guidance.

15 7 Should there be any difference between the requirements to offer guidance placed on contractbased pension providers and trust-based pension schemes? Answer: Trustees must be allowed to offer guidance as this is fundamental to their duty as trustees. Trust law should be sufficient to ensure their impartiality. Clearly the same legal duty does not apply to product providers, so from a legal perspective there is a difference and this should be reflected in the requirements. 8 What more can be done to ensure that guidance is available at key decision points during retirement? Answer: Online access to websites with tools must be encouraged to enable consumers to access guidance during retirement. A.3 The government would welcome views on the options outlined in point 5.15, including their likely complexity, and the burdens they might place on scheme sponsors and HMRC 9 Should the government continue to allow private sector defined benefit to defined contribution transfers and if so, in which circumstances? Answer: Yes it would be retrograde and illogical to increase flexibility for one group of pension plan members and reduce it for another. Furthermore it would encourage employers to undertake bulk scheme reorganisations i.e. move from DB to DC provision since DB plan members would see it as attractive because they would then be able to access more freely their pension funds. This would accelerate the demise of private sector DB pension plans. 10 How should the government assess the risks associated with allowing private sector defined benefit schemes to transfer to defined contribution under the proposed tax system? Answer: The risks are minimal as DB pension provision in the private sector is in run off already. In our answer to question 9, we believe that a prohibition on DB to DC transfers for individuals would have the paradoxical effect of stimulating bulk transfers on scheme reorganisations which we assume it is not proposed to ban.

16 A.4 The government would welcome views on any potential impact of the government s proposals on investment and financial markets. Answer: We think this is likely to be minimal and would point out that the heavy investment in government bonds by DB pension plans is a relatively recent occurrence as DB pension plans have matured and moved into run off.