Solving the at-retirement puzzle

If we see the at-retirement problem as a jigsaw puzzle, it strikes me that we have the individual pieces of the puzzle, but can’t yet see the picture we’re trying to complete.

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The first step needs to be understanding people’s requirements in retirement, and importantly how these will change over time. Without this, we will forever be floundering in the dark creating / selling products in isolation that fail to serve the changing and complex needs of retirees.

Seven years have passed since the pension freedoms came into force, allowing individuals to take their retirement income in more flexible ways other than traditional annuities.

However, there has been little innovation in the at-retirement space. Retirement is the forgotten area of the UK’s defined contribution system; our industry is still fixated on helping people build their savings pots during the accumulation stage. There is still not enough support for when they access their pensions, which is leading to sub-optimal decisions. 

Many savers are fully withdrawing their pension fund as cash, which can damage their retirement wealth. They either miss out on important investment returns by keeping it as cash or put in into a worse-performing or much more expensive investment vehicle.

"We now have a system that helps people build their pension pots, but not necessarily 'pots to pay' income in retirement."

If a basic-rate taxpayer draws a significant lump sum from their pot, this can push them into the high tax-rate bracket. In some circumstances in one fell swoop, they can lose a decade’s worth of pension contributions in tax. 

Meanwhile, fewer individuals are opting for guaranteed income – annuity purchases were down 13% to 60,383 in 2020/21, according to the Financial Conduct Authority’s (FCA) retirement income market data. Drawdown continues to be a popular way to take retirement income, with the most common withdrawal rate being 8% or higher, which can put pensioners at risk of running out of money too soon. Worryingly, the watchdog’s data also shows fewer people are getting regulated advice when entering drawdown, with just 58% of savers taking advice in the six months to March 2021. 

We now have a system that helps people build their pension pots but not necessarily 'pots to pay' an income in retirement. The scale of the problem is evident when even people in the industry who are approaching retirement are scared about making the wrong decision and don't know what to do because there is so much flexibility, and complexity.

Inertia is the pensions industry’s most powerful tool and we have used it to solve the auto-enrolment coverage problem and the accumulation problem through default contribution rates and investment arrangements. 

So, why not use it to help solve the at-retirement problem? 

Towards a new framework

At our webinar last year, DC pensions: sculpting security in post-retirement, former senior economist at the White House Council of Economic Advisers, Professor Jeff Brown, spoke about what a default at-retirement framework could look like. 

He noted that when we add mortality uncertainty into the basic life cycle model, annuities are a “terrific way” to provide guaranteed consumption after retirement. However, the problem in the US and many other countries is that opportunities for annuitisation are not that common – and even when they are available, few people buy them.

Professor Brown thinks that in the US there will be more and more policies designed to encourage the adoption of lifetime income options, and at least some discussion around automatically enrolling people into some sort of a guaranteed lifetime income product.

When we start thinking about the practicalities, it becomes clear that retirement is far too complicated to be solved simply by inertia and defaults.

The main challenge with life annuity contracts is the contract is irreversible. But people’s circumstances could change significantly during their retirement, which could last decades. So, there is a risk of inadvertently defaulting someone into an annuity for whom it is completely inappropriate. For example, if they reach retirement age and have a disease or cancer, which means they will have a much shorter life expectancy.

An individual could also be distracted by other things in their life, such as their health and may not pay enough attention to the fact they are about to be defaulted into an irreversible contract. 

Even if a default strategy included different options to suit different cohorts of people, this would still not be enough given that savers are individuals with bespoke needs, which will inevitably change over time.

Therefore, we must be careful about automatically defaulting people into an irreversible lifetime income stream. 

But at the same time, Professor Brown said we need to take additional action to at least make sure that people have the option available and ensure we're communicating and framing the issues in a way that encourages rather than discourages.

We need a safety net, which defaulting could provide, but it also needs to be flexible. 

Professor Brown suggested one way forward could be a trial annuity where individuals would be defaulted into regular monthly income but without locking in life contingency for a couple of years. 

When thinking about what at-retirement should look like, we need to remember who the DC pension system is designed for. Arguably, it is not designed for the less affluent because the state pension will be their replacement income, and it is not really designed for the higher affluent because they will have other assets to rely on and can afford to pay for advice. 

The system is really designed for people in the middle. How do we create an at-retirement system that provides safety nets for these people but also provides flexibility around how and when they can draw income?

Provide income for basic needs

For example, it could provide income for absolute basic needs and only once those are fulfilled can you start thinking about using your pension for luxuries. Using Maslow’s hierarchy of needs as the framework seems to make sense here.

The FCA appears to be moving in this direction of travel; it would like to see retirement products serving non-discretionary income, which is income that people require to survive. This would be the state pension plus some sort of guaranteed income.

"The ideal post-retirement system is one that has different products which produce different types of income at different times in someone’s lifetime."

We need to move away from being fixated on a pension arrangement that interest increases in line with inflation each year. Rather, we need frameworks that match people's spending habits.

We should also stop focusing on the 'accumulation stage' and the 'decumulation stage' separately. Now with the full freedoms and how people now draw retirement benefits, pensions should be seen as continuum during someone’s lifetime, and pension product frameworks should reflect this.

The ideal post-retirement system is one that has different products which produce different types of income at different times in someone’s lifetime, designed around their spending habits. This would include the state pension, annuities, income drawdown, equity release, deferred annuities, and bring in the concept of longevity pooling.

Collective DC is often cited as the solution to our post-retirement problems, and there is increasing momentum here in the UK with draft regulations due to come out this August. In CDC, investment, longevity, and other risks are pooled across members. 

When compared to longevity pooling, CDC in retirement looks extremely similar. I believe there are many advantages to longevity pooling, which could be an alternative to traditional annuities. According to our analysis, it could generate up to 20% more income than a traditional annuity, be run more efficiently and be less expensive.

Next steps 

We need to consider the science behind people's behaviour and the decisions they make at retirement to create retirement frameworks that genuinely support people into retirement, allowing them to continue to enjoy quality of life. It is also important to be empathetic to the fact that retirement is a time when people are making emotional and lifestyle decisions – not just financial ones. 

"When thinking about what a good retirement system should look like, we need to go back to the drawing board."

A critical piece of the puzzle is how we as an industry engage and educate the individual to do what they need to do. One problem is the industry is under pressure from regulators to communicate certain products and talk about all the risks upfront before discussing the usefulness of the product.

Rather than just talking about products singularly, we need to talk about retirement income broadly to help the individual create a picture of the type of income they will need at a certain point in time. 

While it is, of course, crucial to have regulation in place to protect consumers, in some respects I think it has gone too far. For example, it is stifling product providers from creating products and communicating with people on the right level because they are petrified of repercussions from the regulator if they get things wrong.

When thinking about what a good retirement system should look like, we need to go back to the drawing board. The industry needs to work together with regulators to create a safety net that provides a better chance of helping individuals of reaching good retirement outcomes while providing the flexibility to adapt to individuals’ changing personal circumstances and income needs.