When the UK government introduced pension freedom in its April 2014 budget, it was the latest milestone on a global trend towards offering DC members ultimate choice regarding how to deploy their accumulated savings at the point of retirement. In many ways, providing this choice to members is consistent with the way that most DC plans are set up – namely to serve as vehicles for members to accumulate assets up to their retirement date. In a previous forum post, I argued that this orientation is inappropriate given our beliefs in the true purpose of a retirement scheme. Looking beyond this shortcoming, however, there are two broad questions that we need to address relating to members’ post-retirement situations:
- What are the implications of providing members with freedom of choice at retirement?
- How could the retirement industry help guide them to better outcomes?
Responses to the first of these questions will probably vary depending on where one sits on the spectrum between paternalism and liberalism. My personal view is that, when what consumers think they want differs from what they truly need, they are as likely as not to make sub-optimal choices. Furthermore, there is a well-documented tendency for people to prioritise immediate considerations over those that are far off in the future, and a widespread lack of understanding of the comparative benefits offered by the vast range of available products. A survey of attitudes by The People’s Pension and SSgA found that retirees recognise the need for a combination of flexibility and security from their pension, but at the same time are uncertain how best to achieve the appropriate (to them) balance between the two.
A comprehensive research paper produced by Schroders approached the problem of post-retirement solutions design by contrasting what people need from their retirement savings, with what they claim to want. The ultimate risk faced by pensioners is of running out of money in retirement. Extrapolating from this, Schroders identify the top needs as protection against longevity (outliving one’s savings), sufficient investment growth net of fees, inflation protection and the ability to scale one’s retirement income to varying consumption demands.
In contrast, the Australian government’s 2014 review of retirement products produced a wish-list of the criteria most valued by members. Topping this list were: flexibility (including control over access to capital and underlying investments), the desire to leave a bequest to dependants on death, consistency with pre-retirement products, transparency into the pricing of products, and the assurance of knowing that assets are ring-fenced in the member’s name.
Schroders rightly argue that it is the member’s needs (not wants) that should inform the design of a post-retirement solution, and go on to propose the components that together might do a good job of meeting these needs. Their preferred strategy combines a deferred annuity (purchased at age 65 with payments beginning from age 80) with an account from which withdrawals can be made based on a member’s consumption needs, but also factoring in the amount remaining in the account.
As it happens, Schroders’ solution has a lot in common with a blueprint for post-retirement design proposed by NEST, the workplace pension set up by the UK government. NEST went through a similar process of identifying member needs. Their list combines a stable, real income for life, providing access to lump sums where necessary, the ability to pass on savings in the event of early death (post-retirement), and a requirement for simplicity and low cost. Although on first glance the criteria appear different from Schroders’, they are effectively targeting the same outcomes (NEST gives greater prominence to passing on savings to dependents). The components of NEST’s solution also differ slightly:
- They defer the purchase of the deferred annuity to age 75 (subtle variation in the management of mortality credits relative to investment returns)
- NEST set up a designated cash lump sum account to provide for ad hoc lump sum withdrawals
In totality, however, the two proposals are broadly similar, and suggest a common set of objectives that are appropriate to the majority of people approaching retirement. Which brings us back to the second question above: how might the retirement industry help guide members to a better post-retirement solution? Here are a few suggestions:
- The government (yes, they are an actor in the retirement industry) could endorse a set of requirements that a high-quality solution should deliver
- Products should have a kite-marking scheme that identifies which of the above requirements they satisfy. The kite-marking should be smart enough to enable members to evaluate a combination of different products
- Pension plans should design or adopt a post-retirement ‘core’ option (run by approved outsourced providers) that they recommend as appropriate to most members, and combine this with an at-retirement filtering process to identify those members for whom it is not likely to be suitable.
The above steps are not onerous. And they allow members to retain freedom of choice. But continuing with the status quo leaves DC members confused and exposed to commercial providers who don’t necessarily have members’ interests as their top priority. Our industry can do better than that.