The UK’s retirement savings landscape has been transformed over the last two years following a long period of gradual change. The decline of traditional defined benefit (DB) pension schemes over the last two decades has been very well documented, as the structures that defined the golden age of pension savings slip into maturity and, ultimately, history. 

Recent regulation has revolutionised the way individuals interact with pension saving. The Freedom and Choice in Pensions rules provided unprecedented – and unlimited – access to pension savings to those over the age of 55. 

Savers can access as much of their pension pot as they wish. They can even take it all as cash, paying income tax at their marginal rate. The reforms remove any compulsion to secure pension income but also provide greater flexibility to those who do. The rules also allow pension pots to be passed on to dependents or other nominated individuals. 

The government also introduced rules to allow the creation of a secondary market for those who have already purchased an annuity product to sell it on and release cash. 

This market is due to open in April 2017. Individuals are being asked to take ever-greater responsibility for their own old age. Releasing cash from a pension product may limit the maximum contributions to pension saving in the future. If a lump sum triggers a money purchase annual allowance limit from a DC fund – not all do – the maximum pension contributions in any future year would be £10,000. 

There is also the matter of tax. The more you take, the more you pay and the unwary may be caught out by the change to their tax code – discovering that much of their income has gone to the taxman rather than into their pocket. 

Many industry commentators raised concerns that savers could blow their whole retirement savings in one go, with the purchase of a Lamborghini a favourite analogy. Yet early indications are that the reforms have been treated in a pragmatic manner by most savers, most of whom have released only a portion of their pot. 

What’s next? 

Despite their flexibility, the reforms have made little impact upon resolving the conundrum savers face at the point of retirement – how to access their pension fund. There will be many who retire during the next ten or more years with a mixture of sources of income that will include DB and state pensions, both of which offer income guarantees. 

With pension saving increasingly moving away from DB to defined contribution (DC) funds, savers will increasingly look to secure guarantees, says Maike Currie, director of investment at Fidelity International. “As they approach retirement, savers will want to have some form of guaranteed income to cover their expenses, perhaps blending that with investment that offers growth to at least match inflation,” she says. 

Flexibility is not the main requirement here. Instead, people are realising that without considerably higher contributions DC is not going to meet their income requirements. As a result, they will need to work longer and stay invested longer as well. 

However, the choice of products is rather limited as the reforms were introduced without consultation and with a lead time of just one year. As a result, the choice generally falls between taking an annuity or choosing income drawdown – or a mixture of the two. Drawdown was initially designed for those with sizeable funds – the old rule of thumb was in excess of £150,000 – and was popular among those who did not wish to buy an annuity on retirement. 

Drawdown remains invested and therefore subject to market volatility – exactly what retirees wish to avoid when they are dependent on their pension for their income. 

“These products are complex, so really individuals need advice and that comes at a cost,” says Currie. “It’s disappointing we have not seen more third-way products, but providers have a lot on their plates and I’m not sure how much demand there is at the moment.” 

No point reinventing the wheel 

The lack of innovation should not come as a surprise. The financial services industry has discovered from numerous bitter experiences that if they build it, consumers will not, necessarily, come. The short-lived stakeholder pensions trend is just one example of how the provision of incentives is not always enough to attract pension investors. 

Life companies and other product providers are moving in a more evolutionary fashion, modifying their investment strategies and this is more sensible than launching radical new products, says Tom McPhail, head of pensions research at Hargreaves Lansdown. 

“None of the rules are changing about how the market, asset classes or products work,” says McPhail. “The only thing to change is how you take your money out, so it is right there is a focus on risk and savings rather than trying to reinvent the products. After all, what is there to reinvent?” 

Aviva’s head of retirements solutions policy John Lawson says his organisation took a similar view: “We looked at putting together a packaged product, but it didn’t make sense for the consumer. We feel the best solution – for now – is a blend of drawdown and annuity.” 

The reason is simple, he says. Hybrid or third-way products are difficult to produce, because the cost of the embedded guarantee is high. These products were available in the early 2000s and although flexible were unpopular, as consumers and advisers considered them to be expensive. 

“Variable annuities, which are popular in the US, contain 50% to 80% in fixed income and carry charges of 2.5% to 3%,” says Lawson. “The guaranteed income will be lower than a normal annuity and so you’d need to see a 30% improvement in the investments to catch up.” 

Fixed income doesn’t work in this context, adds Lawson, but income drawdown in isolation carries considerable risk, as you need an equity allocation of 60% to 70% to make it work. 

Dangers of drawdown 

In light of the reforms, the Citizen’s Advice Bureau (CAB) has recently reignited the debate over whether drawdown should be the default retirement position. It has published a paper that says this position should be supported by a comparison tool to assist consumers in choosing the right product. 

The dangers of comparison tools are apparent in the general insurance market, where choices are made on price rather than cover. Some have opposed the inclusion of annuities on platforms for this very reason and McPhail is not convinced CAB has considered these drawbacks carefully enough. 

“A drawdown comparison is all about price and you wouldn’t necessarily know whether you’re buying a guaranteed level of risk, guaranteed income, spouse’s income or death benefits,” he says. 

This applies equally to the occupational arena. Trust-based occupational schemes have come in for some criticism where the trustees have not selected a drawdown-based default, either maintaining an annuity or cash-based target. 

This needs to be assessed in the context of each particular scheme, says McPhail. Individuals are being asked to make active decisions about how and when to take their income, but this could be a dangerous approach if your membership is largely disengaged, as most are. If the member is disengaged, then aiming the default at an annuity is not necessarily a bad thing, says McPhail. 

“After all, if they are disengaged, should they even be in drawdown?” he asks. “The idea that they might be placed in a high equity allocation fund if they are disengaged also makes me quite uncomfortable. “There needs to be more engagement to make members understand they will have to make some of the decisions themselves. And, we could do with some smarter defaults.” 

New girl in town 

In an effort to appeal to younger savers, the government launched the lifetime ISA (LISA) in the 2016 budget as an alternative medium to long-term saving vehicle, to assist firsttime buyers purchase a home or to boost pension saving. It is restricted to those under the age of 40, but savers can contribute up to £4,000 a year and earnings are sheltered from income tax inside the wrapper. At the end of the tax year, the government adds a 25% bonus. 

Though an interesting development, LISA has little to do with securing retirement income, says Fidelity’s Currie. “It’s a useful addition, but you can’t beat what you get from an employer,” she says. “The main game in town will continue to be auto enrolment and people should be maxing out their employer support into pensions before paying money into a LISA.” 

McPhail agrees that most should focus on auto enrolment before entering into a LISA, but does see a specific role for the structure. “LISA is potentially a really valuable solution for the crisis in saving for retirement among the self-employed,” says McPhail. “The selfemployed have turned their back on pension savings as they can’t afford to lock away the money.” 

The road to hell 

LISAs provide the flexibility for savers to borrow money from their fund and incur no charges provided the full amount is paid back. The dangers of removing money from a fund are apparent – the saver cannot benefit from returns while borrowed. There is a stark warning from the US 401k DC schemes and in New Zealand’s KiwiSaver, where a similar structures operate and retirement incomes have been compromised. 

This flexibility “scares” David John, deputy director for the Retirement Security Project at Brookings and a senior strategic policy advisor with AARP’s Public Policy Institute, as dipping into the LISA could cause great damage to retirement savings. 

John notes that in the US there has to be a serious reason to be able to access a fund. However, once done, the standards applied to withdrawals are less strict and may be done on the basis of convenience. 

“A number of young people will think they can save for retirement and use the LISA for something they need or a when a major problem occurs,” says John. “They think it will be easy to catch up, but as we all know, the laws of compound interest don’t work that way.” 

Around 20% of US savers access their 401ks early and if that is replicated in the LISA market, John believes it could set back retirement saving in the UK to pre-auto enrolment levels, but in an environment with even fewer DB funds. 

Back to basics 

LISAs have also renewed the debate about providing savers with ESG investment options. The Paris summit in 2015 threw the matter of ESG into sharp relief and generation Y – or millennials – are said to be more switched-on to ethical saving. 

However, they tend not to save at all at the moment and, for Currie, this has more than a whiff of trying to run before you can walk. Where offered, ESG is used by only a few. And, as returns are anyway so low, investors should think twice about sacrificing anything through a screening programme. 

“Place asset allocation ahead of style and max out your employer contributions,” says Currie. “And before we ask for new products, we should understand how income drawdown works in this newly expanded market.” 

The need for new products is not as great as the need for more people to save more money into some form of long-term saving vehicle. Savers should be setting their goals at meeting fixed expenses with their state or DB pension or an annuity and remaining invested if they wish or can afford to. 

Those who can defer annuity purchase to the age of 80 or 82 will benefit from the mortality cross-subsidy but, in reality, few will have the luxury of such flexibility.