In April 2015 Chancellor George Osborne changed the way people could access their defined contribution pension pots after the age of 55. Members could take a quarter of the pot as tax-free cash and there was no longer any requirement to use the remainder to purchase an annuity.
Unlike defined benefit pensions which provide an income in retirement until death, defined contributions provide a pot of assets on retirement. Turning this into an income requires members to purchase an annuity or invest the pot and use the returns as income.
Of these two options, annuities provide the greatest certainty as they can provide an inflation-linked income until death. But when Osborne made these changes, annuities had fallen out of favour as low interest rates made it increasingly expensive to buy a decent income.
According to the recent report New choices, Big decisions – 5 years on by The People’s Pension, freedom and choice has switched the ‘mental accounting’ of DC pensions by scheme members from a source of future income to a consumption choice.
Mental accounting is concept developed by behavioural finance experts. It describes how people place different values on the same sum of money depending on subjective criteria. This often leads to people making irrational decisions.
Changing how scheme members view their DC pension pot creates future problems. Those approaching retirement are failing to consider either how much income they need in retirement or how long they are likely to live.
Lack of preparation
These concerns are reinforced by another key finding in the report: scheme members are sleepwalking into retirement.
The majority of people leave financial planning for the years after work until very late – if at all. It is rare to find any scheme member which has made a detailed calculation of their future basic living expenses.
“Almost all were taking a ‘suck it and see’ approach, even those who were less than six months from their expected retirement date.
Their focus was more on trying to assemble information on all their pensions and the ‘fun stuff’ – envisaging what they are doing to do with their time – rather than tackle the practical issue of how they will be paying for it,” says the report.
As well as not thinking about how much income they need, members were also unaware of the risks associated with retirement. The Pensions and Lifetime Savings Association says key concerns include investment, inflation, longevity and financial-planning risks.
Managing individual longevity risk is really difficult. “The latest mortality statistics suggest that if you are 65 today you are just as likely to die in the next 10 years − 14% − as live to celebrate your 95th birthday − 18%,” says the report.
If freedom and choice has it much more complex for individual members to navigate their retirement, can it be made easier to navigate? Would better education help? Or should members be provided with better advice? The next post will address possible solutions and which would be the most effective.