Pension Reforms. Key points: By Nigel Aston UK Head of Defined Contribution

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1 Pension Reforms Herald New Era By Nigel Aston UK Head of Defined Contribution Key points: Rather than most people having to secure a pension income by purchasing an annuity, people retiring from April 2015 will enjoy much wider choice over how they utilise their retirement savings Our experience in the US and Australia leads us to believe that people can generally be trusted with the flexibility to make rational long term decisions with their retirement savings, given the appropriate guidance architecture and product choice Default funds, currently relied on by 80 90% of savers to take them to retirement, are well positioned to be the natural vehicle to also take them through retirement Our recently launched Timewise Target Retirement Funds have been designed to be adaptable to regulatory changes such as those announced in the budget. We are currently reviewing the implications of the budget for the Timewise glide path within our research-driven governance framework. The recent budget announcement proposing changes to the UK pension system has generated much analysis about what it means for the industry and, importantly, for the pension savers we serve. Chancellor George Osborne revealed that, rather than effectively having to secure a pension income by purchasing an annuity, all future retirees from April 2015 will enjoy much wider choice over how they utilise their retirement savings. This liberalisation represents a fundamental evolution of a system which, to date, has effectively shoehorned most pensioners into annuity products increasingly perceived as anachronistic and offering poor choice. In a truly transformative set of proposals, future retirees will now be trusted with the same level of responsibility and choice about their retirement savings as afforded to consumers in more mature DC markets such as Australia and the US. ssga.com/ukdc

2 The magnitude of the announcement itself surprised many in the industry (and in particular those firms with a strong focus on selling annuities). However the fact that there has been a change in the rules at all is something that the pensions sector has grown accustomed to. While we may attribute every fresh regulatory change as being the most radical, almost in the same way as we tend to attribute every British winter as being the wettest on record, this time things really seem to have changed forever. So what is actually being proposed? Now: The minimum income requirement for flexible drawdown will drop from 20,000 to 12,000 per annum The capped drawdown limit will increase from 120 per cent of the basis amount (an estimate of the annuity that the member could purchase) to 150 per cent of that amount The 18,000 overall trivial commutation lump sum limit will increase to 30,000 From April 2015: Removal of the caps and limits on income withdrawal DC scheme members must be guaranteed free, impartial, face-to-face guidance about retirement choices Lump sum withdrawals after retirement allowed in excess of the usual 25% tax-free lump sum, subject to tax at the member s marginal rate (rather than the previous punitive rates) Join the Club The proposed liberalisation means that workplace savers will now be trusted to do what they please with their own money. Steve Webb, the pensions minister, stated that this means people may now choose to buy a Lamborghini instead of an annuity and that s fine with him. In reality we don t see this happening. Not only because, with an average pension pot at retirement of below 40,000, Italian supercars would be out of the reach of most. Flexibility in relation to how to allocate pension proceeds at retirement is the norm in more mature DC markets such as Australia and the US. Although there are exceptions, our experience of operating in these markets leads us to believe that people can generally be trusted to make rational long term savings and expenditure decisions. In the US, a recent paper regarding The Drawdown of Personal Retirement Assets*, showed that: The vast majority of people do not make withdrawals from their personal retirement accounts until 70.5, the point when minimum distributions are required Between the ages of 60 and 69, only 18% of individuals make a withdrawal from their retirement accounts in a given year and only 7% of individuals withdraw more than 10% of their total balance At age 70.5, the number of individuals making a withdrawal in a given year jumps to 60% and this increases to 70% for advanced life retirees. The percentage of balances withdrawn during the after 70.5 age group is stable at around 5% per year Whether the UK will follow a similar path remains to be seen, but we remain quietly confident that retirees will not recklessly spend their entire pension savings as some in the media have suggested. Our recent UK member survey questioned DC consumers about their intentions in relation to the 25% they are currently permitted to take in cash. It revealed that, on average, 13% of the cash would be used to pay down debts, 17% spent and the remaining 70% invested or saved. Whilst by no means definitive, this research seems to reinforce what we see in other countries and presents an interesting picture as we look to understand exactly how access to the additional 75% of their pension savings from 2015 would be treated. Exhibit 1: How DC investors will distribute their 25% lump sum cash payout Save in bank Respondents age 55+ who are partially or fully retired Pay debts Spend it Invest in shares/property Source: SSgA Member Survey, December *Source: Poterba, Venti, Wise, ssga.com/ukdc

3 Implications for DC investment strategies We believe the new post-budget landscape heralds an era not only of increased consumer choice, but of better investment defaults. While 90% of people annuitise under existing requirements, from April 2015 the majority may be seeking an alternative investment solution. Retirement savers aren t, however, necessarily engaged, empowered or have the requisite financial savvy to make good rational long-term investment decisions themselves. It may be some time before individuals are willing and able to choose wisely about how they execute their options in relation to pension cash-outs and income drawdown. In the meantime that means we need better default funds and to create an environment in which savers are enabled to make good decisions more easily. This may require offering a small number of alternative default options for participants given it is unlikely a single solution will suit the needs of a particular audience, whilst offering too many solutions could lead to confusion. Perhaps a better way to think about the new DC landscape is not how members will cope with increased choice, but how default design itself can make the post-retirement landscape more attractive and adaptable for them. Default funds, currently relied on by 80 90% of savers to take them to retirement, are well positioned to be the natural vehicle to also take them through retirement and give them more predictability about their retirement income. One of the real advantages of more advanced default funds is that they will be reversible, unlike an annuity purchase that was an irreversible, but lifechanging, decision at a fixed point in time. Default funds that are designed to go through retirement will have an investment mix that can be amended as markets, legislation and behaviour dictate. Also, the complete liquidity of the vehicle means that, post 55, a member can just transfer away if their priorities change and annuitisation or an alternative becomes attractive. Governance in this new environment will remain key both at the plan level so that the membership has access to sensible, sustainable and good value options, but also at the fund level itself, to ensure the investment construct underpinning the plan is doing a good job today and into the future. Life s one constant: Change As managers of pension assets, we need to be cognisant of the range of changes that can potentially impact members and their expectations of how we manage their savings. These include not only alterations to the rules, but also to the way that people behave over time, as well as how markets fluctuate and evolve. Our role as an asset manager is to ensure product design is structured in such a way as to be adaptable to such changes. To date, DC default funds have historically changed little. That s why the better investment solutions for DC members will be those that are constructed to be nimble enough to adapt and respond on their behalf. Solutions which feature well-governed asset allocation, based on real world behavioural and market insights, throughout the investment journey, can deliver this adaptability. Asset allocation must strike a strategic balance between capturing market returns and managing risk over time whilst being intuitive and straightforward to the real people with whose savings we are entrusted. Good investment oversight tends to recognise that people s tolerance to risk changes over time as they move through different phases of their lives; that markets need to be monitored and adjusted for as they move between cycles; and finally that, as regulations change, investment solutions need to be able to continue to deliver the outcomes that pension savers and fiduciaries expect of them. Our research indicates, and we continue to believe strongly, that DC members see themselves principally as savers, not investors. They will look to trusted third parties such as trustees, advisers, service providers and asset managers to take care of the complex investment aspects of their pension provision whilst they think about their own personal saving and expenditure requirements. More than ever we recognise that workplace savers will rely on intuitive, good value default options that have the ability to evolve over time and deliver predictable and repeatable results with a tight dispersion of member outcomes.

4 A future for annuities? From many angles the annuity market has been in need of reform for some time. The annuity solution at retirement was sub-optimal, being effectively mandated by legislation and made worse by a market that was somewhat opaque and, rightly or wrongly, perceived as dysfunctional. Many have questioned the capacity of the market to continue to provide value and choice in its current state. Years of quantitative easing has had the effect of depressing annuity rates artificially. This has been exacerbated by longevity changes that have seen, for example, male life expectancy in the UK at age 65 more than double since 1950 (source: ILCUK, December 2013). Structurally, regulators have long expressed concern with the concentration of annuity providers. This limited the capacity of retirees to access more competitive rates. Legislative constraints limiting consumer choice of when to buy has meant, therefore, that retirees have had little discretion to purchase an annuity based on value. For those in the unfortunate position of having to buy an annuity last year for example, 90% were with annuity rates at record lows. Meanwhile, retirees had no capacity to access higher risk assets or dividend yields that offered far more favourable returns. While the market hasn t been working to the benefit of pension savers at retirement, we don t believe the new reforms necessarily predict the complete demise of annuities. They have a place among the range of choices that can be available to savers. However the decision is one that can now be made on investment grounds in relation to other alternatives, as opposed to a singular choice among a range of potentially unsuitable annuity products. Looking ahead Aside from the changes required by the pensions industry to accommodate the new reforms, one immediately positive outcome is that more people will be thinking and talking about retirement savings and DC. The more we have people thinking about what steps are needed to help them secure the retirement they expect for themselves the better. Increasingly, we believe, DC will be seen as the flexible, consumer-centric product that it always had the potential to become. As investment managers, we aim to help people feel more confident about the prospects for their retirement savings through the knowledge that investment risks are expertly monitored and managed. We aim to provide investment solutions that are adaptable and deliver a more seamless connection between accumulation and decumulation, so it appears to be part of the same single journey. The new pension reforms will see the pension market shift from an insurance driven solution to one that demands a trusted partnership with an investment manager to advise and manage drawdowns and income provision which may or may not include some exposure to annuities. State Street Global Advisors DC solutions Our recently launched Timewise Target Retirement Funds have been designed to be adaptable to regulatory changes such as those prescribed by the recent budget. The structure of the vehicle means modifications to asset allocation or the investment glide path, in order to align with likely changes to member cash or income requirements at retirement, are relatively straightforward. This is particularly so relative to lifestyle products which face a more complex route to effect change. Our investment process is predicated on an asset allocation governance process that researches, assesses, evolves and implements necessary changes nimbly and at low cost. We are in the process of reviewing the implications of the budget changes on the Timewise asset allocation glide path. Following our established process this will involve consideration of likely member behaviour and needs, as well as investment fundamentals. We believe our funds provide robust yet adaptable investment solution for people in workplace pension schemes, underpinned by an intelligent and value-driven approach to asset allocation.

5 As managers of pension assets, we need to be cognisant of the range of changes that can potentially impact members and their expectations of how we manage their investments.

6 State Street Global Advisors State Street Global Advisors (SSgA) is a global leader in asset management, entrusted with more than 1.4 trillion* in assets. SSgA has more than 30 years of experience in the global DC market with over 180 billion in global DC assets. DC clients rely on SSgA to provide a powerful, global investment platform that offers access to every major asset class, capitalisation range and style, including target date funds, diversified growth funds and low-cost index funds. *This AUM includes the assets of the SPDR Gold Trust (approx. $63.5 billion as of 31 December 2013), for which State Street Global Markets, LLC, an affiliate of State Street Global Advisors, serves as the marketing agent. For more information about Defined Contribution, visit: us at: ukdc@ssga.com or call us at: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. 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SSgA has more than 30 years of experience in the DC market with over 180 billion in global DC assets as of 31 December DC clients rely onssga to provide a powerful, global investment platform that offers access to virtually every major asset class, capitalisation range and style, including low-cost index and diversified funds. SSgA Timewise Target Date Fund are designed for investors expecting to retire around the year indicated in each fund s name. When choosing a Fund, investors should consider whether they anticipate retiring significantly earlier or later than age 65 even if such investors retire on or near a fund s approximate target date. There may be other considerations relevant to fund selection and investors should select the fund that best meets their individual circumstances and investment goals. The funds asset allocation strategy becomes increasingly conservative as it approaches the target date and beyond. 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