UK pensions are drifting away from the European approach
The international evidence suggests that more pension freedoms on their own will not lead to good outcomes for most retirees
The UK has been drifting away from Europe when it comes to pensions policy. George Osborne’s 2014/15 ‘pensions freedoms’ revolution moved the UK closer to the individualistic retirement policy long prevalent in other parts of the ‘Anglosphere’, including the US, Canada, Australia, New Zealand, and further away from the European approach, where a stable stream of income throughout retirement remains the primary focus and purpose of workplace pensions schemes. Is this a sensible approach?
Our new comparative study Towards a new pensions settlement — Volume III assumes the UK’s long established policy of making all but the most affluent in society buy annuities was in need of modification, not least because rising life expectancy and low interest rates were driving up the price of annuities. But the international evidence suggests that pensions freedoms on their own will not lead to good outcomes for most retirees.
Most future retirees will need to keep their direct contribution pots invested in markets while drawing a stable stream of income to fund their golden years. In the later stages of retirement an annuity makes most sense. As such, the risks against which most retirees need protection include: investment volatility, involving swings in the value of their pension pot during retirement, and longevity risk, when recipients surpass their life expectancy. Efficient management of these risks demands risk pooling, as the cost of longevity insurance will be lowest if the individual pools mortality risk with other savers, and the most efficient way of managing investment volatility is via membership of a pension fund with the scope to diversify across a wide range of assets.
The UK need for retirement products of this kind is more urgent now than ever, given the comparative paucity of the universal state pension. The UK state pension pre-tax is worth just 22 per cent of the average wage (and just 29 per cent of the average wage post tax). This is lower than in any other OECD country. In Germany, by comparison, the state pension is worth 38 per cent of average earnings pre-tax (and 50.5 per cent post-tax). Even US social security provides a higher replacement rate level for lower earners than the UK. Many UK retirees cannot live in any comfort on the state pension alone. They will need that extra income from their direct contribution pot.
Who can provide it? Based on international experience, the institutions most likely to meet the need efficiently are the new funds (“mastertrusts”) which have emerged to serve the UK auto-enrolment market since 2012. These funds have a legal duty to put their members’ interests first. From an international perspective this legal protection is the norm in many places. In Australia, Greece, Ireland (although there are exceptions), Mexico, Netherlands, New Zealand, Switzerland and the United States, legislation and policy insist that savers are protected by fiduciary law. In other northern European countries, like Denmark and Germany, trade unions co-determine the pension scheme to ensure a ‘member first’ approach. In France, Greece, Indonesia and Italy, the state performs this role as the main pension income provider answerable to citizens.
The UK is unusual from an international perspective in allowing profit-making entities to operate without a fiduciary obligation to sell direct contribution workplace pensions. The 2013 Office of Fair Trading (OFT) study confirmed the problem – that the pensions ‘buy side’ is so weak that competition doesn’t deliver value for money. This is a familiar tale. A host of well-known behavioural biases, including time separation between choice and consequence, perceived degree of difficulty, low repetition of decision making, lack of feedback on results, and a lack of familiar choices, each play their part, as do the vast – often unbridgeable – information asymmetries.
It has long been obvious that annuity price-signals are ignored by a large majority of retirees. While the FCA’s research on consumer responses to pensions freedoms illuminates the obvious reality that most savers are unequipped for complex investment and actuarial-type decision-making as they approach retirement. This results in retirement markets where savers feel isolated, overwhelmed and liable to follow the path of least resistance by staying with the familiar provider, whether it makes sense to do so or not.
The new mastertrusts – whose members make up the vast majority of future retirees – offer UK policymakers a way to harness inertia in the interests of good outcomes. Mastertrusts already do so in the saving phase, and they can do so too in the more complex content of delivering retirement income in a stable way with longevity insurance included.
This would be in line with European best practice – where pension funds do the heavy lifting on behalf of their members both as savers and pensioners.
 The FCA research estimated that switching would rise from 8% to 25%.] %. FCA (2016) Implementing Information Prompts in the Annuity Market, p.26.
Policy Network is delighted to announce the publication of the third volume of Towards a new pensions settlement, edited by Gregg McClymont, Andy Tarrant and Tim Gosling. Hard copies can be purchased from Rowman & Littlefield International.