April 2015 heralded the introduction of the start of some of the most significant pension reforms for nearly 100 years. The April 2015 pension freedoms mean just that: entrusting individuals with the use, in particular, of their defined contribution (DC) pension savings and giving them direct access to their pension savings from age 55 onwards. Individuals are now allowed to take these monies as cash, as a one-off payment or as a series of payments, or to use them for more flexible income drawdowns, or to buy an annuity, or to choose a combination of all these. Additionally, many of the old restrictions on the form of the annuity which had to be purchased from pension monies have been lifted. These freedoms are all subject to the appropriate tax being paid on the withdrawal or use of the pension monies by or for the individual. The basic principle still remains that 25 per cent can be paid out tax free, and the appropriate advice must be taken.
With the new pension flexibilities, more can be done than purely saving for a pension
There is now the possibility of passing pension savings down through the generations. This can be done simply by withdrawing the savings as cash (less the tax) and then using the money in a different way. Alternatively, and more interestingly, individuals can use an income drawdown product where the pension savings in the product can be inherited by the next generation/generations. However, it is still very much early days for this so it is difficult to assess how popular, and how well used, this option might become.
Certainly, as the lifetime allowance reduces from £1.25 million to £1 million from 6 April 2016, there will be less scope for this type of product as individuals are more likely to use their pension pot fully before they die, particularly if life expectancies continue to increase. It seems to be increasingly likely that this type of passing pension wealth down the generations is only of real interest and use to high- and ultra-high-net-worth individuals. That said, research by the Resolution Foundation shows that the recently retired enjoy a higher proportion of the national wealth than the under 45s, with those aged between 65–74 holding 19 per cent of the UK’s wealth.
How ready have the providers been for the changes?
One difficulty with implementing such sweeping reforms is that it has taken providers some considerable time to work out how to change their pension products to reflect the new pension freedoms. Even now, none of the providers have products which provide all of the new pension flexibilities. Perhaps it is not so surprising, given how complex some of the changes have proved to be and how many legacy pension products remain where it is too complex and/or costly for providers to rush ahead and change them.
One key issue the pension industry is still working through, for example, is how a DC fund’s default fund should operate so far as life-styling is concerned, given that there are so many permutations as to how and when an individual should be able to access their pension savings. Interestingly, in January 2016, while providers were working to bring new products to market, 55 per cent of them cited legacy technology as being a major obstacle to them doing so. For all industries, maintaining good quality and up-to-date technology is a challenge and the pension industry is no different.
What about the financial advisers?
Financial advisers are another part of the pension community that is still reeling from the implications of the new pension freedoms. There are strict rules on what pension access individuals can have before they need to take specific advice from a specialised IFA. The government has also, of course, set up Pension Wise to provide free, impartial information and guidance to enable consumers to make the correct decision for them, but this falls short of being advice.
Even though Pension Wise is a free service, the FCA’s findings published on 7 January 2016 state that, of 178,990 consumers, only 17 per cent used Pension Wise. This increased to 22 per cent of consumers with small pots where there is less use of (and less requirements for) regulated advice. It remains important, however, that individuals do take appropriate financial advice if they want to purchase an annuity. The average healthy 65 year old with a pension pot of £100,000 could miss out on 14.5 per cent of income if they fail to shop around.
Insurers have been reluctant to implement pension requests without the individual first having IFA advice, even if legally such advice is not required. There has also been a shortage of appropriate qualified advisers to provide the advice, and those that are have tended to charge higher amounts than the individuals are used to, or are willing to pay. Various solutions to this have been suggested, including using ‘robo advice’ to help fill the gap and/or extending Pension Wise so that it can provide more tailored guidance.
To what extent have the other pension freedoms been successful or otherwise changed the UK’s pension saving patterns?
In terms of boosting pension savings, the pension reforms and the way they interact with auto-enrolment appear to have been successful. The ONS figures for the third quarter of 2015 show, for example, a net investment of £33 billion by insurance companies, pension funds, and trusts – the highest level since the second quarter of 2009. Additionally, the average pension pot, according to research published in January 2016, used to buy an annuity has increased from £22,000 to £42,000.
This may partly be because more people who are accessing their pension monies now have been a member of a DC scheme for longer and so have had time to build up a larger pot. However, the AEGON UK Readiness Report also concludes that the pension freedoms have caused an uplift in pension savings, with 16 per cent saving more as a direct result of the reforms and the average pension contributions increasing from £204 to £450 per month. Not surprisingly, there is less awareness of these changes among the UK’s youth. 20 per cent of those surveyed by MRM Young Money aged between 18–25 admitted they know nothing about pensions and do not save for their retirement.
How engaged are investors?
Despite the increase in pension savings, mandatory financial advice, brokers’ charges, and administration charges will reduce an individual’s final pot considerably. I suspect this, more than anything else, has resulted in consumers remaining wary of the pensions industry, pension providers, and pension products. It is certainly still difficult for a consumer to determine for themselves whether their pension product represents good value, and if it is a good quality product overall. There continue to be pockets of society who are disengaged from pensions. Research from Share Centre says that, despite the recent pension reforms, 11 per cent of those surveyed are still relying on an inheritance to fund their retirement.
What has been the impact on DB schemes?
The DC pension freedoms seem to have proved popular with members of defined benefit, final salary schemes, many of whom have to transfer their benefits out to DC arrangements before they can access their pension benefits flexibly. The number of transfers out from DB schemes doubled in October/November 2015 when compared to the number in January 2015, as shown by the Xafinity transfer value index.
The pension reforms have resulted in some defined benefit schemes considering whether to change the actuarial factors used in the calculation of their transfer values to make transfers out more attractive to their members. Each transfer out which a defined benefit scheme administers reduces the scheme’s overall pension liabilities, and so overall helps the scheme’s sponsoring employer manage its pension obligations. There was concern when the pension flexibilities were first introduced that they would result in a run on member requests for transfers out for defined benefit (DB) schemes, but this does not appear to have happened yet.
Is the system working?
Encouragingly, the Financial Ombudsman has stated that the new pension reforms have so far resulted in a relatively small number of enquiries and complaints, although this does seem to go against the number of pension scams that have been publicised. According to the RSM Pension Fraud Risk Report, one third of pension schemes experienced some kind of fraud in 2015 – more than double the number in 2013. Probably, it is still too soon to determine how successful the reforms have been in practice from this perspective, given the long-term impact the way in which an individual accesses their pension savings will have on that individual – there are likely to be repercussions for many years into the future.
Significant further changes for April 2016 that could be detrimental
Going forward, the whole pensions industry is waiting to find out what further changes, due in April 2016, the treasury might make to the whole system of tax relief on pension savings. The proposals are for either a single rate of tax relief for pension contributions (say 33 per cent), or to treat pensions like ISAs where contributions are subject to tax but withdrawals are not.
In the meantime, the industry is concerned about the impact of reducing the lifetime allowance to £1 million and tapering down the annual allowance for higher earners. The Pensions and Life Time Savings Association (formerly the NAPF) has even gone so far as to say that any move to end pension tax breaks for higher earners would effectively ‘kill off’ work place pensions. A PwC survey of 130 companies showed that 26 per cent of them are reviewing the role of the pensions for all their employees because of the changes to the annual allowance and the lifetime allowance for higher earners from April 2016. Public sector workers are also demanding changes to their remuneration packages if they have already reached the new April 2016 lifetime allowance.
More again in 2017 with the secondary market in annuities
Throughout 2016, and from April 2017 onwards, we can expect to learn more about the secondary market in annuities – the sell back of annuities to insurance companies for cash. To help with consumer protection, consumers will, for example, have to take mandatory advice. The overall concern, however, is whether consumers will receive good value on the sale of their annuities, and initial views are that the new system is likely to be very complex.
Portal Financial Research has suggested that the buy-back terms are likely to ‘very poor’, but the consumer may obtain slightly better value if the annuity is sold back to the insurance company which originally provided the annuity. There is some real value in the insurance company buying back its own annuities – like ending the expense of providing the annuity’s income stream and the capital savings flowing from the cancellation of the annuity. However, this market could also weaken the value of any newly purchased annuities and that market is already weakening.
According to research from Money Facts, annuity rates in 2015 fell for the second year running due to the introduction of the new pension freedoms, low gilt yields, and industry preparations for the new regulations. Rates made a slight recovery over the summer of 2015, but then experienced sharp reductions during the final three months of 2015, with the average standard annuity rate falling by 3.24 per cent in the final quarter of 2015 (according to Retirement Advantage). Perhaps it is not surprising that the FCA retirement income market data from July to September 2015 shows that, during that time, 178,999 pensions were accessed by individuals to take an income or fully withdraw their money as cash, rather than used to buy annuity.
Although changes made recently by the European Insurance and Occupation Pensions Authority (EIOPA) to the new Solvency II regime will help prevent some further rises to annuity rates arising from that legislation, Solvency II is also having an impact on annuity rates according to Retirement Advantage, with the difference between the best and the worst open market annuity rates ranging from 11 and 17 per cent.
So have the pension reforms been a success?
Although it is still early days, taken as a whole, the changes are good both for consumers and for generating consumer confidence. They have also successfully shaken up and forced a somewhat complacent pensions industry to re-invent itself and innovate. It remains debatable whether the next set of pension tax changes due for April 2016 will be so beneficial. The secondary market in annuities still has to evolve and have its regulation set up before judgment can be passed as to whether it looks like it might be a success.
*This article was first published in Private Client Practice – An Expert Guide (second edition) 2016