Should there be an initial conversion rate to turn pot to pension?

According to the FCA’s Retirement Income Study, the average drawdown rate used by non-advised savers is 8% pa. This is almost certainty driven by need rather than sustainability and the great thing about drawdown is it meets people’s needs. The problem is that people’s short and long-term needs are different. When asked about what people need from their retirement savings, people describe an income that lasts as long as they do – an annuity. People know they need a sustainable income in retirement but plump for short term drawdown rates that are unsustainable.

There is a strong case her for Government intervention, there is a market malfunction based on the lack of available product (an annuity is not the mass market solution) and the lack of information or advice on which people can make an informed decision.

We need a standard solution and in recent articles I have been saying that the only at retirement solution that meets my common purpose of what a pension should do (as agreed with the majority of DC savers) is a CDC pension.

To get a CDC pension operating as the default means of turning retirement savings into lifetime income , we need a product that manages the conversion in which the public can have confidence. The intervention needed from Government is both to create a default spending system to match default saving (auto-enrolment) and to make that default a standardised solution which inspires consumer confidence.

That standardisation must include the Government setting the rate at which CDC is paid. As Michael Jones of Eversheds, has written in an important article , it needs to set

an initial conversion rate of DC to CDC which balances attractiveness with a sufficient level of prudence

Because if the market is left to set the CDC conversion rate, we will get the same mess as we had with with profits – namely a race to the top , where CDC funds offering a high initial rate win new business while those who offer prudence are left twiddling their thumbs.

How that rate is set is up to Government and the industry to establish. There is no shortage of brains thinking about this. Willis Towers Watson have a way of doing it that they have used at Royal Mail, there are ways of establishing the rate with reference to the current annuity rate – or gilt rate. There is the CAR (contractual accrual rate)  advocated by Con Keating and Iain Clacher which is the reasonable long-term return expected by a pension fund.

At this stage, we do not have to decide what the conversion rate is but that there is a need for such a rate.  I have argued for such a rate for 25 years. I first published an article on what I call a “Pension Pound” in 1997 as part of a submission to Government on how Stakeholder Pensions might work. The Pension Pound is the cost of buying a pounds worth of index linked pension and I remember back then saying that it was likely to cost around £8. Today the cost of a pound’s worth of index-linked pension for someone at state pension age is more than twice that.

So there is an immediate problem , if you link conversion rates to the gilt or annuity rate, you need something that is more stable. At the same time, you cannot assume a conversion rate that tracks equity indexes, there is no prudence in that. So you probably find yourself creating a long term rate using the method pioneered by WTW which brings you into the kind of area that Con Keating and Iain Clacher promote. The conversion rate is a consensus of what is achievable economically and politically.

Who provides such rates in Government?

There is a department within the Treasury known as the Government Actuary whose job it is to process data and come up with numbers based on growth forecasts, population forecasts. It takes regard of commercial factors such as the needs for people and institutions to get paid and it is quite capable of determining a conversion rate that could be applied for CDC.

But could it do so for drawdown? I think this would be much harder because drawdown is a flexi-product that does different things for different people, there is no common pension purpose for drawdown as it is not managed to last as long as we do (there is not longevity protection so funds could run out or leave a bequest.

Instead of an initial conversion rate, drawdown will give us many such rates, such is its usefulness and such it uselessness.

An actuarial challenge

Establishing a CDC conversion rate would be a very good challenge for the Institute and Faculty of Actuaries to set its members.

Of course it would have to be modelled on a single situation – say a unisex model for someone reaching SPA (66) today? It could have hundreds of sub rates depending on different ages, choices of indexation , second death options and so on. But we need to start with a single rate for CDC which can be agreed on as both prudent and attractive.

I wonder if the IFOA or any of its members will take that challenge. And I wonder if anyone not in that elite circle may wish to challenge the number with their own!

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to Should there be an initial conversion rate to turn pot to pension?

  1. John Quinlivan says:

    Henry, here lies the rub. CDC providers will have different asset mixes, different mortality expectations, different payout framework prudence, different payout targets, different cost bases, different capital / return on capital targets not to mention different emerging cashflow patterns. These and others have been known issues in with-profits / BPA world. If CDC is to even get off the ground in a meaningful way, all of these need to be thought about. I personally haven’t seen any of this covered off yet, but i may have missed this. john

  2. Eugen N says:

    Henry, I think you explained very well, why the CDC is not a solution. People do not save enough, so they would spend their pension provisions in the first 5 – 10 years of retirement. The need for long term retirement income is most of the time sacrified for the more important need to pay for their daughter weeding.

    It is for the State to add a means tested safety net for people to pay housing benefits etc, or for people who own houses, to downsize/ use equity release.

    • henry tapper says:

      Fair challenge Eugen. For retail CDC to be viable it needs reasonable pot sizes- a lot of work needs to be done on whether lifetime incomes are achievable from small pots- but I think it’s wrong to dismiss the workplace pension project too quickly!

      • Eugen N says:

        I do not dismiss workplace pensions, I am very happy they exist. Weeding planners are happy too. They even know to say to the young couple when they complain the price of their wedding is too expensive, that they should discuss with their parents as they could take a few thousands pounds from their workplace/ private pension’s tax-free cash etc.

        Ultimately workplace pensions are saving instruments, which help mainstream workers retire one or two years earlier, or to have better retirement income in the first 5 to 10 years of retirement.

        We need to encourage people to use at least some of these savings as lifetime pensions/annuities (most would buy pension annuities versus CDC etc), but we need a tax break like a pension personal allowance of £5,000 from State pension age.

        Most of the couples would be OK with two full state pensions and £10,000 annuity income, around £30,000 per annum.

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