Pensions ‘liberation’. What price freedom?

9th April 2014 by Mick McAteer

The coverage in the press about the reforms to annuities announced in the recent Budget was almost universally positive – indeed in some quarters it verged on euphoria. Few commentators – even consumer representatives – seemed to raise many concerns about the potential risks associated with the reforms. Now that the initial clamour has died down a bit, hopefully we might see a bit of scepticism and a more objective assessment of the reforms.

The reforms were heralded as being very pro-consumer – giving consumers choice and freedom from the shackles of poor value annuities. So, what’s not to like?  Well, there is plenty to be worried about. It’s also important to question some of the economic myths about choice and competition.

To be sure, the annuities market needed reforming but this was happening anyway. However, we fear that the replacement for the current system could be much more risky as well as providing worse value for those in retirement.

Our concerns relate to variously

the new products that will emerge;

the impact on consumer behaviours;

the availability and suitability of advice;

the impact on costs and value in the pensions market;

the impact on the industry and other products;

the impact on the real economy;

and need for alternatives including new ‘default’ options.

The new products

Of course, the insurance industry abused the concept of annuities (they have form on this) but at least an annuity was a vehicle that allowed pooling of risk – investment risk, market timing risk, prudential risk and especially longevity risk.

Moreover, the main reason why annuities appear such poor value is primarily due to external factors outside of providers’ control such as QE and low interest rates. The euphoria in the press meant that no one seemed to recognise that this affects replacement products in a similar way.

However, the reforms mean that there will be a surge in ‘innovations’ designed to replace annuities – particularly from the asset management industry. Looking at the evidence on the risks and returns available from relevant assets including gilts, equities, cash and so on three preliminary conclusions emerge:

1. a replacement product that is as ‘safe’ as an annuity (guaranteed income, no loss of capital etc) will produce a much lower retirement income than an annuity (due to the cross subsidies in annuities);

2. constructing a new product that will provide the same level of retirement income as an annuity will expose the retiree to significant market risks – the reduction in income would need to be offset by higher capital growth. But, of course, that also runs a significant risk of putting retirees capital at risk at a period in their lives when they should not be risking retirement funds; and

3. even if traditional annuities remain, the unwinding of the market/ removal of cross subsidies means for many people these could be worse value that current products – in terms of the level of income guaranteed.

The impact on consumer behaviours

There seems to be a rather naive view in the media that the greater flexibility and freedom will encourage people to save more for a pension. This is not the case – one of the most significant factors in encouraging consumers to save for the future is having an idea of what they might get back. Uncertainty breeds inaction. And the proposals now mean that consumers will be at risk of withdrawing too much pension money from an early age.

As consumer advocates, we naturally support the principle of consumer choice. However, we know from experience that greater fragmentation and proliferation of products actually inhibits effective choice and decision making rather than empowering consumers in complex financial markets. Obviously, the counter to this is that we can provide consumers with financial education. However, we need to be realistic about the effectiveness of financial education when it comes to dealing with complex, critical life changing decisions.


Rather than reduce the need for advice, the further fragmentation and increased complexity will certainly lead to an increase in the need for good advice from suitably qualified professionals. However, our fears are that, not only will be retirees face more complex choices on retirement products, they will be targeted by more unscrupulous financial ‘advisers’offering solutions to help consumers use pension money to pay long term care, or pay off the mortgage.

Advice is likely to be more costly. Looking at the projections for the numbers coming on stream from defined contribution pensions over the next decade (and therefore needing advice) tell us that there is unlikely to be the capacity to cope in the current system. Consumers will need advice at the point of retirement as before, but the potential risks involved will mean they will need ongoing advice – so the level and frequency of advice needed will be greater.

There is much store being placed on groups like the Pensions Advisory Service (TPAS) and Citizens Advice being able to provide ‘guidance’ rather than regulated advice. But will they have the capacity or simply end up referring the bulk of enquiries to regulated financial advisers?

Costs and value

In addition to an increase in advice costs, distribution costs may also increase. No doubt we will see more ‘intermediation’ in the supply chain, with more layers of funds of funds from the asset management sector. If history is any guide, greater choice, product proliferation and competition is likely to push up costs and extract further value from pension funds rather than drive down costs and improve value for consumers.


There will be some very difficult regulatory issues to confront in the new post-retirement market all within a very short space of time including:what does best advice mean; what is the precise distinction between ‘guidance’ and regulation and where should hand-off be; how well qualified do advisers need to be; how to police the regulatory perimeter; what will the impact be on authorisations; and what does it mean for product governance?

Impact on industry/other products

The reforms to annuities will have a knock-on effect on the insurance industry and therefore existing products and consumers. Some insurers derive a significant share of revenues and profits from annuities. The impact on insurers per se is worrying, but from a consumer perspective there is a risk that insurers will have to offset losses elsewhere by putting up prices/ or increasing the use of risk pricing leading to further financial exclusion.

Furthermore, we have yet to work through the potential impact on defined benefit schemes if large numbers of scheme members want to transfer out of their scheme.

The impact on the real economy

In addition to having an impact on economic and financial resilience at the household level, the reforms could have major impacts on wider economic resilience in the real economy too. Specifically, the reforms could impact on the contribution pension funds/insurers (as owners of equity,bond, infrastructure investments etc) make to wider economic resilience. These financial institutions are an integral part of the UK system of financial intermediation and had been expected to play an even bigger role as alternatives to mainstream bank lending.

The key thing here is to understand how reforms will impact on the asset managers and insurers. They operate different asset allocation strategies and operate to different time horizons depending on the product base.So, the reforms could have significant impacts on asset allocations, the duration of investment holdings, cash flows into and out of the pensions/investment industry – and therefore the real economy. Whether or not this leads to more sustainable and predictable long term capital for real economy (and therefore greater economic resilience) is very much open to question. It could go either way. There might be more matching liabilities within frastructure and so on but equally if people see their pension pots dropping in value they could flee from equities and longer term investments.

Furthermore, there may well be consequences for government borrowing costs – through the impact on the gilts market.

Need for alternatives to promote financial inclusion/financial resilience/ provision for retirement

Overall, we think the reforms introduce a greater risk that consumers will make sub-optimal decisions on retirement. However, for lower/medium income households it may be worse. The unwinding of the annuities market is likely to lead to more targeting/ differential pricing. This will disproportionately affect the less well-off and least financially resilient.

The reforms could undermine efforts to build financial resilience and security. One thing that might limit the damage is if we can develop better value, safer alternatives that in effect become the ‘default’ option for consumers. These default options would serve two purposes:

1. act as a benchmark for comparison and good advice; and

2. provide a better value option to promote competition and help retirees excluded/ priced out of market options.

In addition, if these funds achieve sufficient scale, there may well be opportunities to utilise as providers of long term capital for the real economy/ infrastructure to fill funding gaps that might emerge.

So, there is plenty to be concerned about. To protect consumers from major unintended consequences, we need to address these issues urgently given that we just over one year to prepare for the implementation of the reforms. If anyone shares our concerns, we would be happy to hear from you.


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