A massive failure of nerve – the sad state of our DC pensions

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Last year 460,000 people bought annuities from their DC pensions.  

Two thirds of these people did not bother to get the best rate for their accumulated funds and as a result suffered on average a 10% lower pension than those who did.

86% of the pensions purchased by-passed the CPI/RPI debate and were purchased on a NOPI basis (eg the pension purchased will remain level  ad mortem).

Only 64% of those buying an annuity chose to take a smaller initial pension in return for providing a pension for their partner and only 10% of people elegible for an impaired life annuity bought one.

The DWP predicts that 800,000 people will hit 65 in 2012

Stats courtesy of Tom McPhail – Hargreaves Lansdown

This is a shocking state of affairs. The annuity purchase decision is one of the most important decisions we take it is irrevocable and the implications of this poor decision making will be felt for many years to come.

Buying an individual annuity is not an efficient thing to do. If you follow the logic of a recent piece of work by the Government Actuary which accompanied the Governments recent announcement on Annual and Lifetime Allowances you can see what I mean.

Trevor Llanwarne, the said actuary, has estimated the amount of money needed to provide a pound’s worth of lifetime income increasing by the RPI at around £30. The cost to an occupational pension scheme providing this pension from an existing fund is estimated to be £22.40.

Individuals annuities are 25% less effecient than pensions paid out of occupational pension funds.

So the 260,000 or so people who bought without comparing are compounding their own problem. They are getting pensions almost 50% lower than they could be.

And here’s another sad thing. A lot of the pensions being so poorly purchased  arise from occupational DC pensions or company sponsored personal pension plans.

So some of  the companies who have worked so hard to get their staff a better pension scheme than they could have purchased independently are seeing this work undone at the point of retirement.

Our Government that has consulted, deliberated and eventually regulated on stakeholder pensions, is allowing all of this good work to be dissipated by annuities.

Now I’m sure you are as shocked as I am about all this. It may not come as a surprise as this elephant in the room has been lurking at the back of our minds for some time. Over ten years ago, I listened to Roger Urwin’s impassioned plea for us to do something about this at an NAPF Conference. Mike Wadsworth and the Watson’s insurance division made a concerted effort to wake up pensions people to this problem; we were not listening and kicked the problem into the long grass.

Instead of going away, the problem has grown.

Why?

You can perm from a number of reasons.

  • continued improvements in our life expectancy
  • increased pressure from the European Union  on life company reserving requirements (EU Solvency II)
  • limited availability and competition in the long-dated gilts market (especially for RPI and CPI linked bonds)
  • limited improvements in the payment process for lack of advice on the OMO  (honourable exceptions such as Kerr Henderson and Hargreaves Lansdown)
  • inadequate pension pots requiring individuals to take “jam today” by purchasing inappropriate annuities.

To this sad list of issues we can add the failure of both occupational and contract based schemes to find a better way. Before you say “income drawdown”, I am not advocating people with insufficient funds go that route.

What I’m arguing for is collective drawdown, precisely what allows occupational DB pensions to provide equivalent pensions on a 20:1 basis.

The failure of Fiduciaries to adopt collective DC pensions is  “a massive failure of nerve”. Bitten by the impact of mark to market accounting, companies have turned their back on any form of guarantees on pensions and you will not find more than a handful of employers in the land who will be prepared to guarantee pensions from their DC plans – even though this is permissible and known as the payment of “Scheme Pensions”.

Even if employers were to offer Scheme Pensions, it is difficult to see how they could operate them in a meaningful way. To do so , we need collective funds from which Scheme Pensions can be paid. Most individuals build up their DC pensions in individual pots which de-risk using lifestyle. Were Scheme Pensions to be paid, they’d have to be managed by the company or their trustees on an inividual basis. That’s not going to happen.

Now here at last is hope.

There is a new kind of fund under construction, known as a Target Dated Fund which instead of accumulating individual pots using the established “lifestyle” method, does much the same thing on a collective basis.  Target Dated Funds will mature on set dates and will offer large groups of members the opportunity to club together and have their pensions paid out from their fund – Scheme Pensions.

I very much doubt that individuals would be able to do this for themselves. There will need to be an organisation, the pension provider, the pension sponsor or some other Fiduciary body who will organise payment and ensure that the Target Dated Fund does not run out of money by the time that the last surviving pension (or pensioner’s partner) dies.

There was a day when employers would have looked at providing this service to their staff as a worthwhile enterprise. This is  a much less onerous obligation than guaranteeing not just he benefit but the payment of the benefit. But as I mention above, employers have lost their nerve – an unintended consequence of the way we account for DB plans.

There is further hope. From April 2011 NEST will open its doors. By 2012 it will start receiving massive contributions from employers required to contribute on behalf of themselves and staff through auto-enrolment. By 2020 this system of auto-enrolment will be fully etablished and by 2025, the Target Dated Funds which NEST will employ for 90% of members, will be maturing with hundreds of million if not a couple of billion pounds in them.

I know these dtes seem a long way away but we are talking a sea-change in DC pension provisionhere and the time for us to plan for that change is now.

We cannot expect to see DC pensions become Scheme Pensions until these Target Dated Funds get up to size. Size matters in pensions- the risk of managing out a Scheme Pension with 100.000 members and a couple of billion in funds is a whole lot smaller than you might think. We know how to do it and I challenge the NEST Corporation to show the leadership over the next ten years to make sure this happens.

If  NEST successfully fulfills its early promise and continues to operate the sensible investment strategy it has embarked upon

If auto-enrolment works and NEST is properly funded

If , from 2017, NEST opens its doors to those of us who have small DC pots we would rather be managed collectively

If NEST decides it has the nerve to manage out the Target Dated Funds as Scheme Pensions

If DC operators and the trustees of DC occupational penions follow suit

….we may have finally have a way through this problem.

In the meantime, I understand that NEST is putting in place an annuity selection mechanism that may ensure that those who retire from it get best annuity rates and are guided towards sensible annuity structures. That is the best we can hope for in the short-term.

About henry tapper

Founder of the Pension PlayPen, Director of First Actuarial, partner of Stella, father of Olly . I am the Pension Plowman
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