Shopping around for retiring defined contribution pension investors could add as much to their retirement income, as if the auto-enrolment contribution rate were increased from eight percent to 11.2 percent. Tom McPhail, Head of Pensions Research at Hargreaves Lansdowne, says complacency could leave retirees short changed.
The average benefit to investors from this shopping around process is an increase to their income of 40 percent. This is equivalent to increasing the benchmark auto-enrolment contribution rate from eight percent to 11.2 percent.
Retiring defined contribution (DC) pension investors who shop around with their pension fund could boost their retirement income in two ways. They could benefit from an increased annuity income because of their health; people in poor health or with lifestyle issues such as smoking may be likely to die earlier than the average and, because of this, annuity companies, are often willing to pay a higher rate of income. They do this because if the annuitant dies at a younger age than average, then they don’t have to pay the retirement income for so long. The other key way in which annuity purchasers could benefit is by buying an annuity from a company with competitive rates. The difference between the best and the worst annuity rates on the market at any one time can be as much as 20 percent.
Auto-enrolment (AE) will bring as many as nine million new investors into pensions, the vast majority into (DC) pensions. With the exception of the public sector, membership of defined benefit (DB) schemes is shrinking, while the liabilities continue to explode – private sector employers show no appetite to go back to offering guaranteed incomes. DC pensions are essentially just a tax privileged savings scheme; this means that they carry a range of risks with which the member has to deal. The size of their eventual pension pot and the level of income it generates will depend upon the decisions which the member makes. The size of a member’s DC pension pot will be determined primarily by the amount paid in and the length of time invested. These two factors will outweigh all others. The performance of the underlying investments can also have a big impact on pay outs, whilst the charges paid is one of the least important considerations. Charges used to be more significant, but with most auto-enrolment schemes now charging less than one percent a year, charges don’t matter as much as they used to. However, the most important bit, the actual amount of income the member will receive, depends on the choices made at retirement. Members have to make sure they are getting the right type of income and that the income is being set up at a competitive rate. And it is here that auto enrolment (AE) risks letting down pension scheme members.
A DC pension pot is not automatically converted into income at retirement. The member has to make a choice about how the retirement income is drawn. After taking any entitlement to tax-free cash, in the vast majority of cases, the member uses the remaining fund to purchase an income for life, via an annuity. Around ten percent of pension investors are in the right financial position to choose the timing of an annuity purchase, whether to use income drawdown as an alternative to annuitizing, or to mix and match their approach, by splitting their pension fund between a drawdown plan and an annuity. However, the majority of retiring DC investors cannot afford to take on the risks of using a drawdown plan in retirement because their pension pot is too small and their tolerance to risk is too low. For them, the retirement process is all about making good decisions in converting their retirement savings into an income.
The level of income the member will receive from their annuity will depend upon the shape and the rate of the annuity chosen at retirement. The right choices here are essential as annuities are a once in a lifetime decision which cannot be undone in the future. This means that getting the member engaged with the retirement process is absolutely. The annuity shape encompasses options such as joint life, single life, escalation, and enhanced options. Once the member has selected the right income type or ‘shape’ then they need to shop around for the best terms, the annuity rate. However, at least a third of those with DC pensions do not shop around and simply accept the annuity shape and rate offered to them by their provider. Not only is this unlikely to provide them with the right type of annuity, ignoring such things as widow or widower’s benefits, but also the difference in annuity rate from different providers can be significant. Amongst the top annuity companies, the difference in rates can vary by ten percent or more, costing the member as much as two years income over a typical retirement. If they are unlucky enough to be saving for retirement with a company whose rates are consistently very uncompetitive then they could be as much as 20 percent off the pace.
The process of shopping around for an annuity has been around for over 30 years and pre-dates the birth of the personal pension. Known as the Open Market Option (OMO) historically personal DC providers have not done a good job of either making policyholders aware of its existence, or made the process easy to do. Some of the big criticisms of the past related to the retirement packs issued by the pension providers – principally the insurance companies. These made it easier for the member to simply sign and accept the first rate offered, rather than attempting to shop around for a better rate. Arguably, there was little incentive for providers to solve this issue, since they would then profit from both the pension as it accumulated and the annuity in decumulation. By selling their customers uncompetitive annuities, the pension companies could make a substantial profit from their existing customers who knew no better.
Hardly surprising that shopping around for a better annuity was and still is, significantly easier using a specialist annuity broker or independent financial adviser. Many employers and pension schemes do already direct their members to an independent broker who can take on the job of leading those members through the retirement process, helping them to determine the right shape of income for their needs, searching the market for the best rate and arranging all the paperwork to complete the transaction. In the process, they save the employer money and increase the members’ income. The only people who miss out are the insurers who are no longer able to sell that investor an uncompetitive annuity.
For personal DC pensions, there have been recent significant improvements. A new ABI (Association of British Insurers) code of conduct now requires its member organisations to publicise the availability of the OMO and improve their retirement packs. These newly-designed packs place a higher prominence on the OMO and make it harder for a member to default to buy their annuity with their current pension provider without considering shape or rate. The ABI Code now requires insurance companies not to send out an application form with their retirement packs. This means that members can no longer simply fill in an application form at retirement and send it back without thinking about what they are buying. If they want to buy an annuity from their existing pension company they have to first contact the company and work through a few questions. These questions challenge the investor to think about the shape of retirement income they will be buying, by asking them about death benefits, their state of health and inflation proofing. Only once these questions have been put to the investor can they then obtain an application form for an annuity.
The ABI Code of Conduct will help to address the shape of the retirement income in that it requires all pension providers to ask annuitants about shape before they buy. This is good news. But it does very little to promote shopping around for the best rate. The ABI does plan to publish tables of annuity rates. This means that anyone curious enough to find out will be able to visit the ABI website and see which companies are competitive at different types of annuity rate. Realistically though, almost nobody out there in the real world will do this. The only people looking at the ABI tables will be professional journalists looking for a story and industry insiders. So the ABI Code of Conduct only does half a job even in respect of the 55 percent of retiring pension investors who buy an annuity directly from the insurance company. Furthermore, at present there are no formal mechanisms in place to ensure that members of trust-based occupational DC pension schemes (which generally are not covered by the ABI Code) get either the right type of income or a competitive rate. Trust based pension schemes arranged with an insurance company by the sponsoring employer fall under the new ABI code of conduct but this only covers a minority of such schemes. In spite of the fact that occupational scheme trustees have a legal obligation to ensure that their members’ retirement savings are well used, sadly in many cases, this does not happen.
The Pensions Regulator has issued good guidance to trust based schemes and many already offer some form of shopping around service but there is nothing to stop poor practices slipping through the net. Some schemes only pay lip service to their obligations. They may only contact one or two insurance companies to search for an annuity for their retiring members. They may not obtain medical information to see if the member could get an enhanced annuity. These failings mean that whilst many schemes do the right thing by their members, helping them to shop around for both the best shape and the best rate, the retirement process for many DC investors continues to be a lottery. For deferred members the problem can be even worse. Where retirement is handled internally by an HR or payroll team, there is no mechanism in place to ensure that as a matter of course all members will be actively encouraged to seek out the best shape and rate of retirement income for their personal needs.
Certainly, more can be done! While the Pensions Minister is in the mood for imposing minimum standard restrictions on AE schemes in terms of consultancy charging and a price cap, we believe he should also impose a requirement in respect of the shopping around process at retirement. There should be a requirement that all AE schemes should as a minimum take their retiring members through a shopping around process which encompasses both shape and rate. In order to address the shape requirement, all schemes should at least take their members through the ABI Code of Conduct questions relating to retirement income shape. In order to address rate, all schemes should take their members through an annuity market search encompassing at least perhaps 80 percent of annuity providers (100 percent of the market would be unrealistic, whilst a lower percentage would risk excluding too many of the leading annuity providers.)
We also know that in spite of the ABI Code of Conduct many people still find the pre-retirement packs too long and too difficult to read – only around 1/3rd of people actually fully read the packs. Behavioural economics has already shown us that simply throwing more information at investors is not the way to get them to take action. In fact in many cases you need to give them less information, not more. The way to get DC pension investors to make good decisions around their retirement is to take them progressively through a decision-making process, giving them just enough information at every stage to encourage them to progress further. The use of dynamic medical questionnaires on websites is a good example of this: confronted with a 20 page form, many people give up but by using a dynamic online form which responds to information given it by the investor, it is possible to tease out of investors all the right information to ensure they get the best possible enhanced annuity.
Similarly by asking them to confirm that they have discussed their death benefits with their spouse, they are encouraged to think about the importance of a joint life annuity. At present, investor awareness of some annuity options remains poor. The ABI’s research shows that only 66 percent of investors are aware of enhanced annuities, just 22 percent considered buying one and only 16 percent did actually buy an enhanced annuity. This is in spite of the fact that over 50 percent of pension investors are eligible for an enhanced annuity.
Ultimately, the key to good decision making is the engagement of the pension investor early in the process and ideally in the years they approach retirement. Pre-retirement investment strategies need to be considered, set by reference to anticipated timing and the appropriate decumulation strategy – those minority who will opt for income drawdown should have a completely different investment portfolio leading up until their retirement date, compared to those buying an annuity. The best way to ensure that pension investors make good and well informed decisions regarding their retirement is to ensure that by the time they approach retirement, the language and issues involved are already familiar to them. If this is coupled with a systematic acceptance of the need for a comprehensive shopping around solution for all auto enrolment schemes providing DC benefits then the results should be an effective pension system.