“Unfinished business” – Steve Webb’s pension freedom reset.


Steve Webb is back, doing what he should be doing in a commercial pensions practice. He’s been busy finding ways to make the pension freedoms work, which must be a refreshing change from sorting out underpayments from the state pension. Webb and Boyle’s  LCP “on point” paper, “Is there a right time to buy an annuity” is asking the right question, at the right time in the right way.

The paper, co-written with Phil Boyle,  is grown up stuff, as you’d expect from a former Minister and senior partner of a leading actuarial practice. But it uses an intuitive language which was the hallmark of the man who remains the most quoted pension minister of all time.

There are two words that run through the paper that link financial theory to the emotional point of having a pension . Financial theory lead us to think of “utility” while the emotional point of a pension is to provide “happiness”. The masterstroke is to see “utility and happiness” as the same thing.

What is the paper saying?

In terms of financial theory, the paper says that to maximise our happiness from our pension , we must be bold when we can be (high energy equity funds for drawdown) and insured when we need to be (annuities taking the risk we can’t). The paper doesn’t ignore those who want to leave a pension’s legacy but it assumes that for most people, the point of the pension is to provide an income that survives as long as they do.

By using a simple model, the paper explains why buy an annuity looks more sensible, the older you get. To use financial language “mortality risk increases as an investor gets older”, to use the language Steve Webb prefers ” this means that managing a drawdown pot
to make sure that you don’t run out of money (on the one hand) or end up living excessively frugally to avoid the risk of running out (on the other hand) becomes steadily more difficult as you get older”.

The new (to me) insight is that even if you have a good idea how long you might live on average, the chance of your  individual outcome being significantly different from that rises as you get older. At 60 , I may know that I expect to live to 80 and living longer than that’s not a big financial deal. At 80, every year I live longer than I was expected to – is a very big deal indeed. At 60, I can be bold, at 80 , I need to be secure. At 60 I invest and at 80 , I insure.

This is the unfinished business of the pension freedoms. The pension freedoms give people choices but we need to have the capacity to understand them, which is fine if you are Steve Webb or Phil Boyle with a big financial model to play with, but not so easy if you are in your 80s.

A financial measure of happiness and unhappiness.

The paper is very good about the need to take risk when you can. But it recognizes “loss aversion” and counts a pound lost as causing £2 of unhappiness, whereas a pound gained causes 50p of happiness. Taking the guaranteed income of an annuity as £0 of happiness, it assumes that happiness is harder to earn than unhappiness! This is a very Brummie view of the world and open to challenge!

The financial model LCP has created predicts how for an individual aged 60 , their expected happiness in drawdown compares with their happiness from buying an annuity. A figure of more than 100% means they are happier in drawdown and under 100% means they are happier with an annuity.

Having established a relative percentage happiness score at age 60, they then repeat the analysis for the same individual at age 61, age 62 and so forth. Each time they express their happiness in drawdown as a percentage of their happiness with an annuity. If the figure is always over 100% then they should stay in drawdown throughout. But if there is a ‘crossover’ point when the figure goes under 100%, they expect they will be happier if they switch into an annuity.

The model also gives a 10p in the pound value to bequests, so if you die with £1000 in drawdown, it gives you £100 in happiness! I can live with this means of discounting inheritable wealth. Most people see leaving their pension pot to others as a second (or perhaps tenth) order issue.

What LCP are finding.

By doing thousands of simulations, LCP say their model is telling them things about human happiness derived from their retirement savings. I’m not sure anyone has ever been this bold before.

What they are finding is that for most people there is a right time to switch from drawdown to annuity and for most people that is much later in life than when they start spending their pot. LCP calls this the cross-over point, it’s the “annuity sweet spot”.

It will depend on variables

  • The level of investment risk taken in the drawdown product;
    • How rapidly you want to take an income from your drawdown pot
    • Whether the annuity bought is flat or inflation-linked
    • How much you worry about ‘downside risk’
    • How much you prize leaving an inheritance

But generally the sweet spot for moving from drawdown to annuity (using this model) is between 65 and 70 for someone starting out at 60.

I suspect that this feels a little early to me. Maybe I am not as loss averse as most people, but I think I would want to be invested for longer, especially as I’ll be getting my state pension kicking in at 67.

Here the sweet spot moves into someone’s early 70s and this is because of a clearer approach to investment and insurance. Instead of the “all or nothing” approach – where there is low-conviction investment fund with a cautious (high bond allocation) approach, the hybrid approach models a 100% investment into equities and takes 40% of the pot at 60 to buy an annuity.

the two key findings are

Compared with just buying an annuity at retirement, the ‘hybrid’ approach produces much higher levels of happiness, especially at older ages, than starting wholly in drawdown;

Even for those who partially annuitise at retirement, there is still a point during retirement where it may make sense to annuitise the rest; in this case, the cross over point is in the early 70s rather than late 60s.

Is this just a “load of waffle”?

This approach will not be without its critics, indeed it was good to see John Ralfe reacting with characteristic vigor.

To take John Ralfe’s tweet seriously, we would need to know what he considered “well thought out”. The assumptions on loss aversion are controversial and present an asymmetric approach to what looks a symmetric distribution of outcomes

If instead you took Kipling’s dictum

Then, you would be a lot easier with drawdown than Webb and Boyle’s model supposes.

I would expect to see the sweet spot extend to your late 70’s  (or early  80s in the hybrid approach). To reduce the bias of loss aversion, a product provider might package a solution that found ways of spreading risk.

Alternatively, if you can build greater efficiency into your model by improving returns on the investments and enhancing annuity rates through bulking, then people would be shielded from some losses and get exaggerated gains and might find the outcomes of a packaged solution , easier to live with than following their own pathway.

All models are open to the criticism of “waffle” or “twaddle” , because they deal in speculation. This model has the advantage of having the courage of its convictions and the capacity to articulate them.

Next steps

But we need to speculate, if our utility is to accumulate. As the paper concludes

the search must now be on for ways to make sure individuals give serious consideration to the option of an annuity not
just (and not mainly) at retirement, but throughout their retirement.

This is work which seems barely to have begun and must involve a concerted effort by government, regulators, product
providers and advisers. Without it, Pension Freedoms will remain unfinished business

The roles of insured annuities , structured products or self-annuitisation (as the Australians call CDC), are all important. But we  need to  find a way past the current regulatory impasse which polarizes individual choices between “advised solutions” and “investment pathways”.

What the LCP model is hinting at, is that there are general truths to be learned from what we already know, which can create general solutions which are better than individual guesses.

Steve Webb and Phil Boyle are pointing towards some kind of default “spending” option which allows insurance and investment  to play parts as needed. Whether the trigger for that insurance is some kind of automatic “lifestyling” or through a less severe form of nudge is a matter of product design.

The great thing about this paper, is that it puts these questions firmly on the table and it is for regulators, product providers , advisers and Government to pick this up -oh and bloggers too!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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1 Response to “Unfinished business” – Steve Webb’s pension freedom reset.

  1. Brian G says:

    It’s a good article because it provokes thought. For many people I advised they looked at me as though I was from out of space when they asked me the question “is an annuity or drawdown best in your opinion?” And I then answered “neither” .but this then generated an interest in what I had said. This then generated a conversation about what they wanted throughout their retirement. What made them worried. Whether the price of the certainty offered by an annuity was definitely worth paying. Whether the risk of running out of money in drawdown was too great. And having mature conversation with clients about the pros and cons of both options, and understanding their short medium and long term goals in retirement helped them realise why both options could be both right or wrong. The purpose of a model is to highlight both the average outcomes but also to activate discussion at the non standard outcomes that can occur. Very often a hybrid approach was taken. So annuity and drawdown.

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