Redefining the choice architecture at retirement.



In this blog I talk of Pension Pathways, which is what I call the variable pensions payable to people choosing to transfer their retirement savings pots  into  Collective Money Purhase pensions. Put another way, they are the scheme pensions we would buy from CDC schemes if CDCs were generally available.

I am imagining the choice of a Pension Pathway could be an alternative choice to the existing investment pathways. To make this choice , people need (1) to have the time to choose, (2) a backstop – in case they cannot make a choice and (3) a measure of comparison –  a VFM measure I call the Pension Pound.

1. Giving people the time to choose

We need to swap our pension pots for pensions if we are to rid ourselves of the nastiest hardest problem in finance –  without buying an annuity. Don’t get me wrong – annuities are the gold-plated pension to buy, but not many of us can afford to finance our retirements with investments yielding less than 2%pa.

We could do with buying a  better type of pension. My proposal is that we create a Pension Pathway allowing people to swap their pension pots for a later life income .

But I do not think that people should find themselves taking the pension pathway without an understanding of what is about to happen to their money. It is critically important that people have the opportunity to take an informed choice, even if they do not choose to take one.

The time to choose what to do in retirement starts following the opening of Pension Wise for guidance (our 50th birthdays) and should end at that point where someone knows what they want to do with their pot (s) and feel confident to take the choice that suits them).

However, if people do not take that choice , I see ample precedent for a decision to be taken for them. This is what happens with occupational pension schemes where the concept of a scheme retirement age governs the point at which a pension comes into payment. It is also how the state pension works, state pensions come into payment at the state pension  payment.

Only with Defined Contribution pensions, do we have no point at which something must happen which turns people’s pot into a pension.

2. Giving people a backstop through a scheme retirement age.

My proposal is that we reinstate the concept of a scheme retirement age for DC schemes and that this age should normally be the state retirement age (as it is with Nest).

A scheme retirement age becomes important when it becomes a backstop when something has to happen. In my proposal, a scheme would have to provide an investment pathway or a pension pathway as a default into which people would be defaulted at scheme retirement age. We might best think of the process as a “continuation option” from which people can opt-out anytime before scheme retirement age.

Such a continuation option need not always be a Pension Pathway. But I hope that trustees and scheme funders will conclude that the proper means of returning money to those saving for a pension, is with a pension.

3.  “Pension pounds”, a measure of comparison

I have always liked the idea of “pension pounds”. I have written about them  many times over the past 20 years. They are the best way of explaining the value you get for the pension you buy.

How pension pounds explain the difference between cash and pension

Many people stuggle to understand that a pension pot is not the same thing as a pension. I know this because I have been advising people on this for fourty years and I know some people who still think their pot is their pension. The Pension Pound introduces the concept of an exchange rate.

Let us say that the exchange rate between everyday pounds and pension pounds is one for ten. That means that you can get ten pounds a year of pension for one hundred pounds of cash.

A pension pound is worth a pound every month for as long as it is needed so someone purchasing one at 60 would have 480 monthly payments if they lived to 100. That’s why a pension pound costs a lot more than an everyday pound!

People understand VFM through the exchange rates within annuity choice

People struggle to understand what determines the cost of a pension pound. We know this from the annuity market where the cost of indexation , of spouses pensions , of “5 or 10 years certain” or of sex, age and good health passes most people by.

It is as much as most of us can do to compare annuity rates between providers at the age we are at outset, which is why most annuities were (and still are) bought without indexation with the minimum of frills.

The annuity rate is a simple example of the exchange rate, people measure the conversion rate as pound v pension pounds (though they don’t use that language). Once they have understood the basic principle of a pension pound, they can choose to understand the subject in more detail.

We will see this happening later in the blog, as we look at other ways of getting income in retirement (such as drawdown and Pension Pathways).

Annuities are simple as they don’t  ask us to consider risk

The open market option for annuities created a framework for people to chose the right annuity provider for who they were and what they wanted. It is a simple system that works reasonabley well.

But annuities have one very important aspect to them which is standard – they are considered risk-free and , despite some annuities being backed by riskier assets, we trust in insurers providing abbuities  not to fail. We have good reason to – there is a strong solvency regulator behind them.

The pension annuity is considered “risk-free” , so “risk” is not a consideration in making the choice of annuity provider.

People purchasing an annuity are making an unreversable decision to be paid an income at a certain rate for a certain time (usually the rest of their life). Once people have worked out they want an annuity, the choice of annuity is simple.  The risk of taking that decision is within the rate of exchange , the cost of a pension pound.

Investment pathways assume people can make choices for their retirement on a much more complex basis.

By contrast, people are asked to make choices about investment pathways based on what they might want to do with their pot in the future. The investment pathway is  a means to get to a later decision on how the money is spent. The assumption that people can chose what to do , is not yet proven. Most people don’t even know where to start (Pension Wise).

The investment pathway assimes what is best for most people once they have decided what they want to do with their pension pot. Since there is no way for the organisation offering investment pathways to know the appetite for risk of each person using each pathway, “what’s best” is just based on their plan for their pot.

But most people don’t have a plan they feel confident in nor any understanding of the risks involved from drawdown, or being in cash, or choosing to invest for the next generation. , Since people don’t know what they want,  investment pathways haven’t yet proved very popular.

Taking “risk” out of investment pathways? Or just transferring it to the most vulnerable?

The investment pathway’s doesn’t have to make an assumption about people’s appetite for risk. Instead it matches their investment solution to people’s aspirations for their retirement pot. This concept of “matching” presupposes people know the consequences of buying an annuity , cashing out, rolling up their pension pot or drawing down from it. The theory goes that , once you know what you do, you should focus 100% on making that happen. But sadly most people don’t know what to do, so investment pathways don’t really help manage risk either collectively or individually.

Because annuities are “risk free”, it’s thought that the pathway to an annuity should be “risk free”.  The annuity pathway is  designed so that  people know  the annuity income they will get, regardless of changes in annuity rates in the meantime. The annuity pathway invests in “matching assets” which protect people against fluctuations in annuity rates.

The same goes for people looking to cash out in the next five years- they move into cash.

People who have no plans to touch their pot get an investment pathway with long-term horizons -typically investing in patient capital designed to maximise returns over time without focussing on immediate volatility. Once again the risk is matched (so long as people understand the risks of not spending the pension pot in the first place).

There is no measure capable of comparing the various risks posed by inflation, mortality, markets or health necessary to make reasonable comparisions. But the problem is particularly acute in income drawdown .

Which path would you choose?

The pathway to income drawdown is particularly problematic

People who drawdown are moved into a pathway which can be used for drawdown. Since everybody can choose their own rate of drawdown, a further assumption has to be made about the amount of risk within the future drawdown fund. The investment pathways towards drawdown vary in  composition because no-one can agree on the right level of volatility for any given rate of drawdown, let alone multiple levels of drawdown and multiple attitudes to risk. Drawdown pathways fall down because it’s hard to know what people want and to match expectaitons.

The concept of the risk in the outcome is assumed to be understood, so the pathway is supposed to  match the investment solution to that risk. But , as we have just seen, the problems occur when simple products like a long-term investment fund, a cash fund and an annuity protection fund are replaced by the complex product called “drawdown”.

In the next section , I look at why income drawdown is such a hard product to offer to the mass market. Let’s begin by looking at what people’s expectations are for their retirement income. Firstly, let’s think about what happens when things go wrong!

We accept conditional indexation but not conditional cuts in pensions!

The idea that a pension goes up at different rates is commonly accepted, we talk of state pension increases in terms of the triple lock and debate the merits of CPI, CPIH and RPI for occuaptional schemes.

We accept that at times like this, the promise of the triple lock may not be met and that the state pension might fail to meet our indexation expextations.

We are also prepared to accept that sometimes we may not get the same pension at outset as we’d been hoping for. When a scheme sponsor asks for its scheme to go into the PPF, then people awaiting getting their pension can expext a “haircut” of 10% or more.

But – even if a scheme goes into the PPF, pensioners do not receive a drop in their income. They are protected by priority orders. The idea of a pension having to be paid at a lower rate for whatever reason is simply not in pension scheme DNA. Conditional indexation maybe – cuts in nominal pensions no.

So what happens when Income Drawdown goes wrong?

Income drawn down from a pension pot presents a different challenge than that of a wage for life pension. That is because it does not pretend to offer protection agains the pot running out before we do. The drawdown can be maintained so long as there is money in the pot, but no longer.

This is what makes income drawdown so frightening to people and it is why people with reources tend to put their trust in advisers to set the income drawdown rate and ensure that it is adjusted to meet their need for future cashflows. This deal with an adviser usually involves accepting that the income drawdown is variable and that the risk of things going wrong is mitigated by good advice (this assumes that advisers take some responsibility for outcomes). There is some evidence that some people use advisers (or at least their PI insurance or FSCS) as their protection against drawdown going wrong, there is plenty of precedent for this happening in other areas of advice.

Where an adviser is not involved in setting or managing an income drawdown rate, then the choice of the rate is solely down to the person who owns the pot. This is where pension freedoms really hits the buffers, there is no protection for people who aren’t taking advice on drawdown , other than the drawdown investment pathway which is no more than a suggested investment solution based on the best efforts of a contract based pension provider and its IGC or GAA.

Those providing investment pathways can point to the risk mitigation of matching the policyholder’s expectations; it is difficult to argue that expectations weren’t met when there was no requirement on the provider to know its client in more than the most superficial way.

Who provides guidance to people looking to drawdown from their pot?

The short answer is “noody”? There is no guidance, no “rule of thumb” nor any reliable modeller that can provide people with a DIY template.

And there is no protection for people against them drawing down too fast or too slowly, people are left to make the nastiest hardest decision in finance on their own. Put simply there is no risk mitigation for people who try to turn their pot into a pension via drawdown – the decision is “hit and hope”!

Put in terms of “pension pounds”, requiring people to create their own “exchange rate” between everyday pounds in a pot, and pension pounds paid from drawdown, is not fair. We need a better way of turning pots to pensions with an exchange rate that people can understand as fair and reasonable

We can see the results of people having to set their own rates for their pension pounds, typically people set a rate of 8% with many people taking nothing at all and a substantial number of people drawing down at an exchange rate that can’t be considered sustainable.

In summary, we do not have any measures to work out how to drawdown, even the pension pound is of little help.

A Pension Pathway offers a different choice.

A pension pathway is different from an investment pathway because it doesn’t lead to a decision in the future, it requires a decision to be taken when people decide to follow it. In that it is like an annuity purchase, though it may be possible to offer transfer values from Pension Pathways if that is considered valuable.

That  decision is that people exchange their everyday pounds for pension pounds paid to them without any guarantee of the level of pension payble in future but with a promise of a pension payable in a certain way at a certain rate conditional on the successful management of the scheme behind the pathway.

This also has similarities to the agreement with an adviser when entering into drawdown. The main difference between advised drawdown and a Pension Pathway is that the latter ia part of a collective endeavour which is managed and maintained as a colllective money purchase arrangement under regulations designed to minimise the risks of the promise not being met.

How does the Pension Pound idea work for Pension Pathways?

The idea of the pension pound is to explain both the exchange rate and the risk within the process of exchanging an everyday pound for a pounds worth of lifetime income. It is a simple measure that can compare total certainty (an annuity) , with “hit and hope” (non-advised income drawdown). Somwhere in the middle is the Pension Pathway which provides a promise of an income for life at a certain rate. Measuring the risk of that promise  not being met must be a further metric that explains the assumptions behind the calculation of the exchange rate in a way people can understand.

I believe that can be done, using a score, or a traffic light or similar intuitive metric backed up by an explanation of what has driven the score or colour of the light.

People cannot be expected to work out the likelihood of the assumptions behind the exchange rates offered by Pension Pathways being reasonable, heroic or over prudent.

These assumptions will have to include the internal rate of return of the underlying fund, the drag of cost and charges for running the scheme and the long term liabilities of paying pensions till the day people die. And to a large degree, these will need to be assessed on the quality of the scheme’s covenant.

But I am confident that those who understand the measurement of risk can provide risk assessments of Pension Pathways and in the next section I explain how this might be done.

Assessing the covenant of a Pension Pathway

We have got used to thinking of the scheme covenant for a scheme coming from a sponsoring employer – this is what workplace pensions are all about. But Pension Pathways are post-workplace products (or at least help people move away from a dependency on work). So we have to re-understand the nature of the covenant,

There are three elements to the covenant of a Pension Pathway type CDC scheme. Firstly there is the covenant with the scheme’s fiduciaries (let’s call them trustees) who are responsible for the maximising of member outcomes through the exercise of their fiduciary duty.

Then there is the scheme funder, who is the commercial organisation establishing the scheme and ensuring it is sustainable through its proper promotion.

Finally there is the membership of the scheme – all the other people following the Pension Pathway who provide the scale on which the assumptions can be based.

The only participation of an employer is as a “feeder” to pension pathways, either by directing those retiring directly or by promoting Pension Wise to explain the available choices  (of which the pension pathway is one).

It is not the employer, but the workplace pension, that offers a Pension Pathway as the continuation option at the scheme retirement age. Importantly, the employer is not responsible in any way for the choice that a retiring worker makes.

We can make some reasonable assumptions about organisations that could set up Pension Pathways based on their existing fiduciary capability, there capacity to organise and promote the Pension Pathway and there ability to make reasonable assumptions about the rate of exchange – their Pension Pounds.

But for organisations to want to offer Pension rather than just Investment Pathways, we need to look beyond current choice architecture and join up the choices avalable from contract based personal pensions with the scheme pensions that we associate with occupational pension schemes.

This will require a large amount of co-operation between all stakeholders involved in the provision of retireement income in the UK.



About henry tapper

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