Feathering the Nest. Many people have little interest in how pension savings are invested

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1 Feathering the Nest Sharon Collard discusses how people s understanding of risk may explain their inertia over pension savings and the implications for the new pension freedoms Public discussion about pensions in the UK is frequently couched in headlines such as pension crisis and ticking time bomb, with warnings about the significant number of people not saving or under-saving for later life. Government analysis, for example, estimates that 11.9m people are not saving enough to maintain their standard of living into old age 1 although many of these could improve their situation by saving a little more, something that, perhaps not surprisingly, failed to make the headlines. An increasing majority of people in the UK accept that it is the individual s responsibility to ensure sufficient retirement income, as opposed to the responsibility of government or a person s employer. The proportion has increased from 52 per cent in 2006 to 60 per cent in Even so, people do not necessarily feel able or motivated to exercise this relatively new responsibility. This article explores how the public s understanding of risk may help explain low levels of engagement with defined contribution (DC) pensions and planning for later life, and considers the implications for the new pension freedoms that begin this month (April). The UK personal investment culture One possible explanation for historically low engagement with personal pensions in the UK is that, on the whole, personal investment is just not part of our national psyche. Not counting personal current accounts in credit, the most common non-pension savings products held by households in the UK are savings accounts and Individual Savings Accounts (Isas). 3 In the tax year , 78 per cent of the money saved into these accounts was in cash Isas. 4 Only a small proportion of households has any other type of non-pension investments where capital is at risk (Table 1). When it comes to pensions, official statistics show that just 15 per cent of households in the UK have wealth in personal pensions and 14 per cent have wealth in current occupational defined contribution pensions. 5 The pension journey is characterised by inertia and low engagement. Automatic enrolment in workplace pensions is perhaps the ultimate behavioural nudge, aimed at harnessing the UK s Table 1: Percentage of households in the UK with formal financial assets (excluding private pensions), 2010/12 Savings accounts 58 Isas (including Peps) 48 National Savings certificates and bonds 22 UK shares 12 Insurance products 1 7 Fixed term bonds 11 Employee shares and share options 6 Unit/investment trusts 5 Overseas shares 2 UK bonds/gilts 1 Includes life insurance, friendly society or endowment policies (excluding mortgagelinked endowments). Excludes term insurance policies. Source: Wealth in Great Britain Wave 3, Chapter 5: Financial wealth, ONS, deep-set inertia towards pensions in order to increase saving for retirement. More than 5m people have so far been automatically enrolled into workplace pensions in the UK, with opt-out rates running at around one in Once in a pension scheme, UK members, as in many other countries, are unlikely to make any active investment choices or switch investments, contrary to any good intentions expressed in research. 7 For example, almost all the assets Many people have little interest in how pension savings are invested under management (more than 98 per cent) for the 1.8m members in Nest, the state-backed workplace pensions scheme, rest in the default option. 8 Members may make 1. DWP (2014), Scenario Analysis of Future Pension Incomes. Available at: 2. MacLeod P, Fitzpatrick A, Hamlyn B, Jones A, Kinver A and Page L 3. ONS (2014), Wealth in Great Britain Wave 3, , Chapter 5: Financial wealth. 4. HMRC (August 2014), Individual Savings Account (ISA) Statistics. 5. ONS (2014), Wealth in Great Britain Wave 3, , Chapter 6: Private pension wealth. 6. Nest Insight 2015: Taking the temperature of automatic enrolment 7. See, for example, Collard S (2009), Individual investment behaviour: a brief review of research. University of Bristol, Personal Finance Research Centre. Also, Collard S and Moore N (2010), Review of international pension reform. DWP Research Report April / May

2 PENSIONS an informed choice to remain in a default fund but, far more likely, they have little awareness or interest about how their pension savings are invested. Only 4 per cent of Nest members have registered online with the scheme to receive more information about their pension than the statutory minimum. 9 Through a saver s eyes: are pensions fit for purpose? While the UK population has a fairly poor understanding of investment risk, people generally do grasp the risk-reward relationship and the idea of capital risk the possibility that investors may lose some or all of their original capital and re-invested returns. 10 In fact, public awareness that the final value of personal pensions depends on stock market performance has increased: from 61 per cent of people surveyed in 2006 to 72 per cent in At the same time, a significant proportion remains stubbornly reluctant to take investment risk. 12 People tend to be intolerant of risks that have certain characteristics characteristics that we see in DC pensions and personal investments more generally. The risks are perceived to be unknown, uncontrollable, not easily reduced, with catastrophic potential, and there seems to be an inequitable distribution of risks and benefits. 13 Through a saver s eyes, therefore, DC pensions may seem very much at odds with the purpose of pension saving. The fundamental idea of personal pension saving and notably the title of the 2006 White Paper that ushered in major workplace pension reforms is There is a real risk of people outliving their pension income Security in Retirement. But rather than offering security or any guarantee of a comfortable retirement, in savers eyes DC pensions may appear fraught with risks the risk that they may not get back the money they invested and, more particularly, the risk that their pension savings do not make sufficient returns to provide an adequate income in retirement. In either case, the principle of deferred gratification no longer holds, making immediate gratification, or liquid cash savings, seem a sensible choice. A tendency to catastrophise, born partly from poor understanding of probability in relation to investment risk and partly from a natural emotional response to the idea of financial loss, means that people see the chance that their money is at risk as the same as the chance of losing everything. 14 Other risks and uncertainties about pensions, such as the legacy of mis-selling and 8. Nest Members Panel Annual Report 2013/ Ibid. 10. See, for example, FSA Consumer Research Report 33 (2004), Consumer Understanding of Financial Risk; and Financial Services Consumer Panel (2007), Investment Risk Rating: Consumer attitudes towards risk. 11. MacLeod P, Fitzpatrick A, Hamlyn B, Jones A, Kinver A and Page L 12. See, for example, Cass Business School (2014), How do savers think about and respond to risk? Pensions Institute; MacLeod P, Fitzpatrick A, Hamlyn B, Jones A, Kinver A and Page L (2012), Attitudes to pensions: the 2012 survey. DWP Research Report 13. Slovic P (1987), Perception of risk. Science (new series), 236 (4799), Nest (2014), Improving Consumer Confidence in Saving for Retirement, 9. mismanagement, and the general low trust in longer-term financial products, 15 help reinforce these concerns and in the savers eyes seem to support the case for doing nothing or else leaving their money in cash savings. But what s it all for? Added to the shapeless spectre of investment risk, savers also feel uncertain when it comes to trying to work out the material benefits of saving in a DC pension. Only about a third (36 per cent) of private pension savers who are pre-retirement age say they have a good or reasonable idea what their income in retirement will be; 21 per cent admit to having a vague idea, while 41 per cent say they have no idea. 16 Even the common rules of thumb that people use to work out how much to save for retirement tend to be based simply on their current situation, rather than any projections or predictions of a particular outcome. 17 Many DC members say they want practical help to work out what a good outcome looks like for them and their family and the steps they can take to achieve that outcome. In recent research with DC members, two-thirds said they would like help to work out how much they should pay into their pension each month and three-quarters said they needed help to work out how much their annual income was likely to be when they retire, from all their income sources. There was strong support for employers to help DC members get the whole picture about what retirement income they should aim for and the contributions needed to make that happen. 18 Motivation to engage By offering savers more options about how they use their pension savings, the new pension freedoms reduce the risk of people buying poor-value annuities. The new freedoms have hardly been out of the news since they were announced and Nest reports a seemingly positive impact on the public profile of pensions: 34 per cent of people say they will think about planning for retirement sooner, increasing to 40 per cent among year-olds. And 29 per cent of people overall say they are more likely to increase their pension contributions as a result of the new freedoms. 19 But we should treat these encouraging signs cautiously. People s pension aspirations, as expressed in research studies, do not necessarily translate into action. An important lesson from international research is that large numbers of pension investment options at the accumulation stage cause information overload, resulting in confusion and greater use of defaults. In other words, more choice is generally not a great behavioural motivator. We are likely to see similar issues at the decumulation stage when decisions may well be irreversible. 15. The Which? Consumer Insight survey in December 2014 shows 19 per cent of respondents trust longer-term financial products, up from 14 per cent in December 2012 the lowest of all sectors that the survey asks about. By way of comparison, 52 per cent of respondents say they trust the food/grocery sector. 16. MacLeod P, Fitzpatrick A, Hamlyn B, Jones A, Kinver A and Page L 17. Hardcastle R (2012), How can we incentivise pension saving? A behavioural perspective. DWP Working Paper Barclays (2014), Steps towards a Living Pension. 19. Nest Insight 2015: Taking the temperature of automatic enrolment. 26 April / May

3 Sixty-seven per cent of women in their early 50s believe they will live for less than 20 years after the age of 65. But official projections suggest that women of this age are most likely to live between 26 and 30 years. Source: Challenges in the new world of pensions. Population Patterns Seminar Series. ILC UK and Partnership, October 2014 The UK public s risk aversion will also be as much of a challenge, if not more, at decumulation as accumulation. Coupled with a tendency to underestimate our life expectancy in retirement (see box above), the desire for income security at decumulation means a real risk of people outliving their pension income by some way. 20 While this doom and gloom scenario may be well founded, there does seem to be a real opportunity to harness the positive public mood about pension freedoms to encourage pension savers present and future to engage more with these important decisions. 20. ILC UK (2015), Making the system fit for purpose: how consumer appetite for secure retirement income could be supported by the pension reforms. Given such low levels of engagement, even a small increase would be a step in the right direction. Practical help for savers to work out the outcomes they want to achieve from their pension, in terms of the pounds and pence, but also the sort of life they want, and the steps they should take to get there, would be a start. This might provide the motivational nudge people need to engage, because it helps fulfil a basic human need for personal control and autonomy which research shows is largely absent in people s relationship with pensions. At the same time, international evidence shows that many people just want to save, forget, collect when it comes to pensions, making good defaults and the fiduciary responsibility of trustees all the more important. Sharon Collard is professor of personal finance capability at the Open University Business School s True Potential Centre for the Public Understanding of Finance (True Potential PUFin). The establishment and activities of True Potential PUFin have been made possible through the support of True Potential LLP. Views expressed by True Potential PUFin may not reflect those of True Potential LLP To live and let die Sales of annuities look set to fall sharply. Edmund Cannon discusses the reasons for this and explains why buying one can still be a good idea From this month (April), individuals who have a personal pension fund will no longer be required to use it to buy an annuity. Preliminary signs are that purchases of annuities will fall sharply despite the fact that buying an annuity is usually a good idea. Much research supports annuities investment, but there is a long-standing annuity puzzle : few people buy them. Why this is, and whether the government was correct to stop compulsory annuitisation, is what I shall examine here. What is an annuity? An annuity, or more strictly a life annuity, is a financial product where an individual makes a single lump-sum payment (premium) in exchange for a regular income guaranteed to last until the individual, the annuitant, dies. In the UK, annuities are sold by life assurance companies that are heavily regulated to ensure that the income will be paid. Only one life assurer, Equitable Life, has failed in recent years. The principle of annuity is simple. The fact that many individuals report that buying an annuity is complicated and bewildering suggests that there may be problems of poor financial literacy. It is true that there are variations on annuity products. A husband and wife might, for example, decide to purchase a joint-life annuity that carries on paying an income until they have both died. Annuitants must also decide whether they wish to have an income that is constant in nominal terms or one that is inflation protected. The UK annuity market has specialist providers selling enhanced annuities to individuals with bad health, who are given larger regular payments because they are likely to receive fewer overall. It is possible that these choices increase pensioners confusion, although the range of products should improve the value of annuity purchase by matching particular goods to specific individuals. The benefits of buying an annuity The simplest way to describe the benefits of an annuity is to say that a retired individual is guaranteed an income and, therefore, does not need to worry about having enough resources. Two important components of an annuity are providing investment management and risk-free income over the potentially long period of retirement. These are valuable services, especially for the most elderly who may find decision-making difficult (eg if they have Alzheimer s), but these services could, in principle, be provided by other financial products. The unique and most important feature of an annuity is April / May

4 PENSIONS that it insures the annuitant against longevity risk. The magnitude of this uncertainty is illustrated in the chart below. According to the best estimates of the UK s Institute of Actuaries, at age 65 a male can expect to live to about age 87. Most pensioners underestimate their life expectancy, but the key point is the uncertainty: there is a 25 per cent chance that a male will live beyond the age of 92. The advantage of buying an annuity is that the pensioner has a secure income however long he or she lives even if it is to age 115, in which case the retirement will presumably have been longer than the entire working life. Without an annuity, there is a significant chance that an individual will run out of money before dying. Pensioners could minimise the chance of running out of money by spending very little, but then their standard of living is likely to be lower A quarter of 65-yearold males could still be alive in 28 years time Probabilities of living to given ages than if they bought an annuity. It is true that an annuitant might die relatively young: there is a 25 per cent chance of dying before the age of 81, in which case the value of the annuity payments received by the annuitant would be less than the premium paid. This is sometimes used as an argument against buying an annuity. But to use this argument is to fail to understand how insurance works: the only way that life assurers can afford to pay out to people who live to a very old age is to redistribute from the shortlived to the long-lived. The annuity puzzle Academic economists have attempted to value the utility benefits of having the longevity insurance that annuities provide. As with all models, the conclusions depend upon the assumptions made, but a wide variety of assumptions yield similar conclusions, namely that pensioners should have a substantial proportion of their wealth in annuity form, ie a regular income for life that insures against longevity risk. For many poor people, this is true: the poorest members of society have few financial assets and their biggest source of income is the basic state pension, which is similar to an annuity since it is an income guaranteed for life. But these people have no choice over being annuitised, since they do not have the option to receive the basic state pension as a lump sum rather than as an income. Similarly, many middle-class pensioners do not buy an annuity because they already have an income guaranteed for life through an occupational pension. So, many pensioners do not buy an annuity because they already have annuitised income and do not need more. The annuity puzzle comes where individuals have wealth that is not automatically converted into an income for life and choose not to buy an annuity. For example, in the US, few pensioners with a $401(k) personal pension buy an annuity. The largest annuity markets in the world are, or were, all underpinned by compulsion (the UK, Chile, Switzerland). There are three broad classes of reason why personal pensioners may be heavily under-annuitised: 1. There may be market failures in the annuity market. 2. Individuals may be irrational or make poor decisions. 3. Individuals may be rational and avoid annuitisation for strategic reasons. A common criticism of annuities in the UK is that they are unfairly priced: because pensioners are forced to buy annuities, life assurers face a captive market and can raise premiums. Since most annuities are sold by just half a dozen life assurers, there could be monopoly power. However, if annuities were excessively priced, then new life assurers could enter the market and undercut existing providers. What matters is not the number of providers or compulsion to buy, but whether or not there is free entry. Various studies have shown that the mark-up on annuities is not excessive, suggesting little monopoly power. If anything, compulsory annuitisation has created a larger market and enabled firms to lower Source: Author s calculations based on Institute of Actuaries PML92 table with medium cohort projection 28 April / May

5 costs through economies of scale. Certainly, the range of specialist products in the UK for rare health conditions is larger than in smaller annuity markets elsewhere. A more obvious explanation for the high price of annuities is that they are expensive to provide. The chart showed that, on current projections, as many as a quarter of 65-year-old males could be alive in 28 years time. But this is only a forecast and forecasting 28 years ahead is in itself risky. If life expectancy increases faster than expected, then a much higher proportion of annuitants will still be alive and the annuity provider will still be required to provide them with an income. Equitable Life failed partly because it offered excessively generous annuity guarantees that it was unable to fulfil. An alternative explanation for the annuity puzzle is irrational behaviour. Recent research in economics has emphasised psychological determinants of economic behaviour. This is particularly relevant where decisions are only made once and individuals cannot learn from past behaviour (most people only retire once). I have already mentioned that individuals tend to underestimate their life expectancy. There is also a considerable body of evidence that most individuals are unable to make good long-run investment decisions: the fact that financial services professionals are paid high salaries suggests that financial planning requires substantial skills not shared by the population at large. Finally, there is direct evidence that individuals responses to questions about annuities depend on the way that information is presented framing effects rather than the content of the information, which suggests that individuals are not fully rational. Should annuitisation be compulsory? In the previous section I argued that individuals may choose not to annuitise partly because of irrationality. From the perspective of public policy, the question is whether compulsion will make things better for society as a whole and whether such restrictions on individual choice can be justified. One of the consistently most popular institutions in the UK is the National Health Service a form of compulsory health insurance. If it is believed that annuitisation is a good thing, then it is partly a political judgment whether irrational pensioners should be compelled to buy an annuity. However, we also need to consider the genuine meaning of compulsory. In the UK, it was only ever compulsory for a pensioner to buy an annuity with his or her personal pension wealth. Strictly speaking, only 75 per cent had to be annuitised, the rest could be taken as a tax-free lump sum. So, compulsory annuitisation was only ever compulsory for someone who chose to save in a personal pension. It was the quid pro quo for receiving substantial amounts of tax relief. If compulsory annuitisation was the price to be paid for tax relief, the current change in policy is effectively a move to giving some individuals tax relief for free. The amount of tax lost is substantial: for a higher-rate taxpayer it is 40 per cent relief on both contributions and investment returns. In the tax year , total relief on personal pension contributions alone was 5.5bn. As occupational pensions are gradually replaced by personal pensions, the tax relief on personal pensions will certainly grow. (Total tax relief on contributions is 28bn or 2 per cent of GDP.) Even after netting off tax receipts from pensions in payment, tax relief is 16bn. Providing such largesse (predominantly to the better off) without a corresponding annuitisation requirement raises two dangers. The most obvious is that some rich individuals will now put more money into pensions purely for tax avoidance. Although there used to be safeguards to prevent this, the current proposals have removed them (albeit within limits to contributions and the size of the taxexempt pension pot). The second problem is that without an annuity, some pensioners will run out of wealth during retirement and fall back on means-tested benefits. It will be difficult to know whether pensioners who do so have done so deliberately or suffered bad luck without an annuity there is no insurance against longevity risk and it is hard to see how a future government will be able to deny additional support to such pensioners. The fact that the new system is being introduced with extreme haste creates the risk that pensioners may be given inadequate advice and that some pension-related financial services might not be well regulated, which could create legal risks for the government. (A worrying precedent is that poor regulation of Equitable Life resulted in the government having to provide compensation.) More importantly, pensioners who run out of money still have the vote, a sanction that no government can ignore. Most people go through their entire life without having to choose whether to buy an annuity and so annuities are poorly understood. International evidence suggests that pensioners may under-annuitise and suffer risks to their financial wellbeing in extreme old age. Although it is questionable whether the government should compel pensioners to Without an annuity, some pensioners will run out of wealth Most people tend to under-estimate their life expectancy buy annuities, it is debatable whether current changes in policy have been thought through sufficiently carefully. References Brown J, Kling J, Mullainathan S and Wrobel M (2008). Why don t people insure late-life consumption? A framing explanation of the under-annuitisation puzzle. American Economic Review, Papers & Proceedings, 98 (2), Bütler M and Teppa F (2007, The choice between an annuity and a lump sum: results from Swiss pension funds. Journal of Public Economics, 91, Blake D (2014), The consequences of not having to buy an annuity. Pensions Institute Discussion Paper No Edmund Cannon is reader in economics at the University of Bristol, a fellow of the Pensions Institute at Cass Business School and has been a visiting professor at the University of Verona. He is an editor of the International Review of Economics Education. His research interests lie in pension economics and economic history April / May