Many of pension freedoms’ true challenges yet to surface

Under the surface - Volcanoe

I sat open-mouthed in the House of Commons four years ago as George Osborne announced the end of a national retirement system based on annuities.

Three years on from the law change, several trends are clear.

Overall, we remain in what I call ‘Income Drawdown’s Phoney War’: as long as the vast majority of retirees have defined benefit (DB) pensions alongside their defined contribution (DC) pots then the really knotty challenges of decumulation – investment, longevity, and inflation risk – are unrealised. Running out of money is not possible.

The risks have become greater as billions flow into non-guaranteed solutions.

But this ‘phoney war’ is coming to an end more rapidly than I expected, because of the sheer volume of DB to DC transfer assets. When people with little experience of the financial markets – such as the steelworkers of Tata in South Wales – place their whole financial future in the hands of an income drawdown portfolio, then the risks have become greater as those billions flow into non-guaranteed solutions.

Buying an annuity in your mid- to late-60s is usually inefficient from a financial perspective. This reflects life expectancy, which – contrary to some recent reports – continues to rise. Buying an annuity much later in retirement generally makes more financial sense because of rising mortality credits and the ‘smile’ consumption curve, meaning we spend less in our dotage than we do as new retirees.

Instincts, emotions and beliefs

Measuring retirement products by such financial efficiency is beside the point because individuals’ decisions at retirement are motivated by a much wider range of instincts, emotions and beliefs. What academics call the ‘annuity puzzle’ (why don’t people buy annuities) is not a puzzle at all. Nowhere around the world do individuals buy guaranteed products in large numbers unless compelled to do so.

The bequest motive is a powerful one and making pensions inheritable has transformed the way in which advisers and their clients approach drawdown. This ‘second act’ of Osborne’s reforms was as revolutionary as the first.

As long as interest rates are low, designing sophisticated but not complex guaranteed products is an uphill task for asset managers and insurers.

Finally, no investment strategy can abolish the risk of running out of money. Only spending rules can avoid the crystallisation of investment losses. It’s why good financial advice is utterly critical in drawdown.


The article above was previously published on Aberdeen Asset Management’s ‘Thinking Aloud’ blog on 3rd April 2018