British retirement savers will benefit greatly from new pension rules, though inevitably some will squander the opportunity.
Still, better to make one’s own mistakes than have them made for you by a system which, as it was, laid out a banquet for pension providers and produced table scraps for savers.
Under reforms announced on Wednesday, Britain will scrap pension rules which obliged about 75 percent of retirees with defined contribution, or 401k-style, pension plans to buy annuities.
Instead, most savers will have far more freedom to allocate their pensions as they like at the age they become eligible to take them, with the ability to take more money sooner and to invest more or less as they wish.
Fitch commented on Thursday that while much of the former annuity money would flow to other investment products, those were likely to have a lower margin for sellers.
The problem with the annuity system, which was designed to protect savers from themselves by insuring they had a stable income in retirement, was twofold; low interest rates and the lousy value offered by annuity providers.
The story illustrates key problems in private pension provision, and shows just how difficult it is to design a system in which savers are treated fairly and are given the best chance of an adequate retirement income.
Ideally pension systems either need a reasonable alignment of interests, as in defined benefit plans in which the company is on the hook for promised benefits, or a reasonable balance of power between consumers and providers.
The British system, as it was, had neither.
In essence British retirement savers represented a captive market for insurers selling annuities. While it is hard to know exactly how bad the deal was which annuity sellers were offering, a look at their share prices after the news broke that their products were now only optional is a good guide. Legal & General (L&G), one of the largest such providers, saw its shares fall by as much as 15% after the news, despite the fact that its entire retirement division, which sells far more than annuities, produces less than a third of its revenues.
Other annuity providers also fell, notably Aviva Plc, down 5% Wednesday, and Prudential down about 4%. Ratings agency Fitch commented on Thursday that while much of the former annuity money would flow to other investment products, those were likely to have a lower margin for sellers.
It should also be noted that the market segment with perhaps the worst reputation for value among annuities was those offered to people with documented health problems, whose shortened life expectancies made them particularly rich pickings.
Accidental victim
The broader problem with annuities, of course, was one no-one saw coming: the lowest interest rates in British history. As market interest rates are the most powerful force in setting how much an annuity pays on a given lump sum, savers who came to retirement in recent years, after the Bank of England cut rates to all-time lows, saw a huge drop in what they could expect by way of income.
That’s an accident of history, but one which produced long-term suffering for those who came to retirement amid low rates.
While it is possible that we now live in a low-interest-rate, low-return world, the annuity system offered no way for savers to hedge the risk that returns would actually be good in coming years.
In defense of the industry, an annuity represents a transfer of risk, from the individual to the seller, who must pay up regardless of market conditions. That’s a genuine service and deserves a return, just likely a lower one than British companies have been able to extract.
To be sure, this reform, like so many others, will produce some perverse results. Buy-to-let flats come to mind as the kind of thing many British retirees may find attractive - after all property only ever goes up, right? People who put their pension money into leveraged, illiquid and very likely overvalued single assets are likely to wish in 20 years time they’d lost money little by little instead with an annuity.
The new system is an improvement as it devolves power down to those most concerned and with the best information about their personal situations, needs and desires: the saver.
Offering that kind of adult autonomy to people who are, after all, adults, is worth a great deal.
You never know, some might even buy annuities, especially if the rates in a no longer captive market improve.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)