We have gone from full annuitisation, to drawdown up to age 75 and then annuitisation, then drawdown to age 75 and alternatively secured pension, followed by full drawdown beyond age 75 and then flexible drawdown, to the current proposal of being able to do what you want from 2015.
This was a freedom that no one expected and is a long way from the ‘annuities deal’ often quoted by the Treasury.
“In return for the generous tax relief on pensions saving, the Government requires individuals to turn their pension fund into a secure retirement income.”
This longstanding requirement dates back to the 1920s and was reiterated in the 2006 Treasury Paper on the Annuity Market.
Over the years the industry has often pushed for more freedom, either from annuities or from the GAD rates applying to drawdown which also restricted income based on gilt rates. The standard response from the Treasury was to resist such change, arguing that such freedom would endanger the sustainability of an individual’s fund. We are all living longer and retirement income needs to last for the duration.
The responses have been predictable and in some ways politically aligned – freedom of choice as opposed to state collectivism and the need to protect people from themselves.
Interestingly, if you look at some of the learned research on the subject (particularly from the US) it is strongly demonstrated that, for investment efficiency and utility in retirement, annuities should be the product of choice.
This, however, assumes that people act rationally, when in fact the behavioural psychologists show that this is not the case. People do not act rationally and decisions can be affected by a whole raft of heuristics.
So where does that leave us? Well we have a set of transitional changes – GAD rates have increased from 120% to 150% and the minimum income for flexible drawdown has been cut from £20,000 p.a. to £12,000, all leading up to the proposed new regime from April 2015.
From April 2015 it is proposed that individuals over the age of 55 will be able to take up to 25% of their pension fund as a tax-free lump sum, and then draw as much or as little from the rest of the fund as they wish, with withdrawals taxed as income at the individual’s marginal rate.
The other main immediate change increases the limits for commutation of trivial amounts, but I will not cover these in this article.
The other part of the reform is the promise of some kind of face-to-face guidance/advice for all. (Again this is beyond the scope of this article, as the industry has yet to discuss how this is to be delivered, who will deliver it and, most importantly, whether it will be guidance or advice.)
Potentially this really ups the game for financial planning and the question of the day is, will people spend it or save it? And what happens if they spend it?
The Pensions Minister, Steve Webb, indicated that freedom of choice was key, and used the perhaps rather eccentric example that people could take their pension money and blow it on a Lamborghini if they so wished, but once all their money had been spent the State would provide no more.
This is assisted by the move to the new flat rate pension, which will be based on an individual’s NI contribution record and will not be subject to means testing – so spending all your pension would mean having to rely on that State pension.
Will the standard approach be that of the individual who reaches retirement with a pot of pension money, works out his prospective life expectancy and his required income for each year and invests accordingly?
Possibly, but perhaps that’s all a bit simplistic – factor in risk profile, capacity for loss, the need for specific capital lump sums, minimisation of tax and the wish to leave an inheritance, and you have the need for real financial planning.
As well as all the normal investment products, the range of available investments will also include annuities for a degree of certainty of return. For the first time these annuities will have to stand on their own two feet as an investment option, and I am sure innovation and marketing will be key.
As part of the planning process, risk profiling and cash flow modelling systems will really come into their own at the inception of a financial plan in terms of reviewing and monitoring a client’s needs, goals and day-to-day circumstances.
There are likely to be other spin-off effects of the new flexibility regarding divorce, bankruptcy, the interaction of inheritance and long term care, the provision of spouse’s benefits and even the use of QROPS.
There is still a lot of water to flow under the bridge before we get to next April and there could still yet be game changers - the General Election, the interaction of the new regime with current legislation, the interaction of legislation with regulation and, I am sure, a few more unknown unknowns!
For me the final part of the equation will be the information and education of consumers. To start with there could well be a bit of a reaction against annuities and the big institutions that supply them - this new freedom will be seen as a real attraction and could well be subject to a bit of a knee jerk reaction in the number of people that leap in. Unintended tax consequences, poor investment strategies and a range of other issues could lead to poor consumer outcomes and the onus will be on us as an industry to minimise such problems.
This was definitely a Budget for financial planning, but to enjoy the benefit we will need to work hard to get real engagement and the trust of consumers.
Mike Morrison
Head of Platform Technical
AJ Bell