Currently the Government has a strategy for guiding people who don’t employ a financial adviser to the right choice for what to do with accumulated pension savings after the Minimum Normal Retirement date (55 going on 57 in six years time).
The strategy is called “investment pathways “, which is sometimes advertised as a concept (note the use of the word “is”),
and sometimes as a series of strategies (here the word is “are”)
Both clips are taken from Fidelity’s web-advertising, showing that even the operators of investment pathways are unclear about how they should be promoted.
In this blog, I look at what experts call “choice architecture” and make two bold suggestions to make investment pathways easier to choose and follow.
I am hopeful that we will see details shortly of the Government’s plans to strengthen guidance along the lines of the FCA’s “guided sales process”. This would make it easier for Government to implement these two suggestions.
Summary of the suggestions
- That choice is presented at retirement as it is to people starting saving into a new pension plan. A strong default is put in place down which most people will tred.
- That the default choice should be a pension pathway, with investment pathways as secondary options.
The pension pathway
The pension pathway can be thought of , as Australians now think of their Retirement Income Covenant.
The retirement income covenant (RIC) passed through Parliament on 10 Feb 2022. The RIC comes into force on 1 July 2022 and requires super trustees to develop a retirement income strategy for their members, improving the financial outcomes for Australian retirees.
The overriding principle is that the RIC takes into account other benefits available to members – including their means tested state pension. We have a flat state pension which like Australia’s means it is more important to those with low income elsewhere. The state benefits (including pension credits) are guaranteed. The Australian system can teach us that a non-guaranteed private pension can compliment the guarantees from the state and that guarantees become progressively less important, the more private retirement income you have.
It is important to understand that the RIC is not about guaranteeing people a set level of income, implicit in all the elements within it is the idea that income in retirement might go down as well as up, insuring against income going down is an option but it is not the default option.
This is how one pension provider in Australia illustrates what a Retirement Income Strategy looks like
The idea is that all members of a Super (similar to our workplace pension) transfers their pot value (with access to capital) and can invest in a RIC that protects them against investment, inflation and longevity risks. This is what we could call a “pension pathway” , building on the existing pathway framework.
The pension pathway would be a “first among equals” strategy which would be a default option applied not later than at the saver’s state pension age but earlier at the saver’s request.
The benefits of such an approach is that Trustees or the fiduciaries of GPPs (IGCs and GAAs) can be satisfied that investment, inflation and longevity risks are being covered, that the retirement income covenant is complete.
Mark Johnson of Just Retirement told attendees at a recent Pension Playpen coffee morning that by dispensing with the guarantee that income would never go down, a pension pathway could offer 35% more income than a guaranteed annuity.
For that reason, I am suggesting that the pension pathway should be a retail version of the CDC product being developed for Royal Mail and others, offering those who have pots , the option to convert pots to pensions at a rate more than a third higher than an annuity but with less security of income.
Let’s look at each risk
Modern portfolio theory is no different from ancient portfolio theory, you need to diversify across markets using the benefits of pooling many savers money to purchase and manage assets efficiently.
Diversification provides some natural smoothing of the volatility in value of individual assets but further smoothing can be applied either on a discretionary or algorithmic basis, such smoothing has a cost and that cost is met by lower returns.
Fiduciaries can help decide the balance between volatile returns – and resulting income – and smoothed returns – and resulting income.
The risk of inflation eating into the real value of retirement income has seemed secondary over the past 10 years of low inflation. But as inflation has picked up in the past 6 months, it is back on people’s worry list (risk register).
Fiduciaries can target the amount of inflation protection offered to people using their default pension pathway and this will lead to conflicts between marketing departments (who will want jam today) and those who think it more prudent to set today’s income rates lower with an expectation of greater inflationary protection in the future. Managing this message is going to be difficult, I suggest that a consensus position will emerge, perhaps targeting CPI inflation proofing.
Any pool of money that belongs to people needs replenishing with new joiners , for existing participants will eventually die. Managing the distribution of remaining assets from those who die while still in the fund, is a key task for pension pathways which differ from drawdown in that the rate of income distributed takes into account the pools liabilities as well as its assets – based on the life expectancy of those remaining in the pool.
It is a judgement call of those operating the pension pathway, whether they choose to offer standard rates of income to all in the pool or whether each individual is offered their own rate based on their individual life expectancy.
It is also a judgement call, whether the pathway protects just the member or the member’s nominated partner (and to what degree)
Flexible Access to Funds
The Australian approach has been to allow those who wish to withdraw part or all of their money from the Retirement Income Strategy to be able to do so, I think this is important for any pension pathway in the UK. While this will lead to some problems where people take money, pay tax and live to regret it, the popularity of a pension pathway will be radically improved if people thing they are not committing their money for ever.
Similarly, competition will be likely between pension pathways which should be encouraged. People should be allowed to move between one Pension Pathway and another provided the cost of moving is clearly stated. People can then calculate the risk of moving to a strategy that they hope will do better, and know the amount of ground needed to be made up – to move. We do this calculation when we move houses.
Inevitably, pension pathways that consistently see greater outflows than inflows will fail, but this need not lead to market failure. We will see consolidation as we do with workplace pensions.
The most effective way of getting people to take good decisions is to present choice in a way that most people get what’s right for them. We know that most people are happy to go with defaults where they do not want to take a decision for themselves and a strong default is one of the features people like about workplace pensions.
I can see no good argument for not deploying the same methodology for the choices we take at retirement. The default choice for most people is to take a proportion (25%) of their pot as cash- though people can choose to have this paid as enhanced pension with the same or better tax advantages).
The default retirement income strategy can be determined by the fiduciary but it must show it balances the needs of people to get a good rate of income (generated by investment), protection against inflation (generated by investment in real assets) and protection against living too long (the use of longevity credits so survivors benefit from the death of those who pass before them).
A return to annuities?
I think it unlikely that any fiduciary would make a guaranteed annuity , the default pension pathway. It might provide members with all three protections, but the rate of income offered to do so, would be so unattractive that it would likely see mass migration of savers to other pension pathways. Ultimately the funder of the platform on which the pension pathway was offered would intervene.
But it is possible that our retirement income covenants would include pension pathways that were partially guaranteed. This would be a matter of negotiation between the fiduciary and the funder of the platform. Hybrid solutions may emerge and may prove popular. In Australia , it is possible to offer different solutions to different cohorts of those on the pathway and it’s not hard to see lifestyle solutions emerging over time where the utility of an annuity is offered to those in extreme old age (as promoted by Steve Webb). But care will need to be taken with all such variants not to dilute the capacity of the pension pathway to achieve its purpose of providing a simple pension pathway to all members.
What of the existing pathways?
I see some people opting out of the default pension pathway and continuing to use “flexi-access drawdown” because they want complete freedom on how their money is managed. I see those who want the freedom of SIPPs , wanting this freedom – though many who are currently in SIPPs may choose for a less demanding product – a pension pathway.
I see some people wanting their money as cash – whatever the consequences. We live in a free country where people can choose to do as they like so long as they aren’t a harm to others. I do not worry about the moral hazard of a few blowing their savings on Lamborghinis and then becoming pariahs of the benefit system – that doesn’t happen enough to drive policy
I see some people wanting the security of a guaranteed annuity. Probably a lot more than at present when they consider the trade offs between a guaranteed and non guaranteed income product. But with an estimated 35% lower income – for the sake of the guarantees, I see the majority of people opting for a a pension pathway where the income isn’t guaranteed.