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Given that we are only a year into the reform, it remains too early to understand the long-term implications of choices made by UK retirees, but looking internationally can also guide us

Pension Reform in the UK

Pension policy in the UK has been going through major upheaval. The year 2014 saw the introduction of automatic enrollment of employees into workplace pensions. Equally significant are reforms announced by the Chancellor of the Exchequer that transformed how savers could access their pensions.

Historically in the UK, retirees with defined contribution savings faced a heavy tax penalty unless they converted their savings into a guaranteed income for life. In effect, this meant that there was a requirement to annuitize for most retirees. However, starting in April 2015, individuals have been able to withdraw their pension savings in whatever form and whenever they want from the age of 55, and the tax penalty has been removed.

The government rationalized the decision to change the policy on the basis of a number of fundamentals. First, there was an underlying philosophical explanation: if people are prudent enough to save for retirement, then they could be expected to be prudent in how they used their pension savings. Second, the state pension is becoming a more generous base than it was in the past. Third, the government hopes that the reform will make pension saving a more attractive proposition as people are given greater freedom and choice over how they spend their investments. Fourth, there is also a hope that providers will innovate and thus provide a wider and more tailored suite of products to meet the very varied retirement and aging paths of older cohorts. These and other gains could be significant—but so, too, could the potential long-term risks.

 

The US, the UK, and Australia: Common Lessons?

Given that we are only a year into the reform, it remains too early to understand the long-term implications of choices made by UK retirees, but looking internationally can also guide us.

The UK, in many ways, is following the international example set by countries such as the US and Australia. In those places, there is significant reliance on defined contribution pensions; retirees there have significant freedom over how they spend their pension savings (though regimes are not identical across any two places). Drawing on this international evidence, our research report, Golden Years? What Freedom and Choice Will Mean for UK Pensioners, sought to gain a fuller insight into the range of possible long-term outcomes for UK retirees, depending on how they spend their pension pots.

Although consumers in Australia and the US display a wide range of behaviors, a number of patterns stand out. The most obvious difference in these comparator countries to the UK in the recent past has been the rates of annuitization: 75 percent in the UK before the reforms, compared with 5 percent in Australia and 10 percent in the US.

Given the low levels of annuitization, we also wanted to understand at what speed those who managed their own risks in the US and Australia spent down their pension savings. Drawing on research by academics such as Professor James Poterba, we identified three paths to model alongside an annuity. Among them was the average (mean) rate at which Americans withdraw their savings—namely, at 8 percent of their pension assets per year. We also modeled two rates from Australia. The average (mean) behavior in Australia is a cautious one, generally preserving capital by reducing wealth by less than 1 percent a year. However, a significant minority spend their pension savings quickly. An estimated 1 in 4 exhausts their pension pots by the age of 70, and as many as 4 in 10 by the age of 75. Our research, therefore, models what we term a “quick-spending Australian,” which reflects spending behavior that sees the person running out of savings by age 75 (in the UK this equates to 10 years past the state pension age for men).

A number of results stand out. First, were UK retirees to follow the cautious Australian decumulation path, they would face a very low risk of running out of savings, even if they lived longer than average. However, being cautious with savings has the downside of meaning lower incomes in retirement than would be possible through purchasing an annuity. Following one of the quicker-spending paths leads to lower incomes in later life and pension savings running out before life expectancy. Although the UK’s state pension means that individuals would not be dragged below our official poverty line, but they would fall below other measures of “low income.” One particular risk identified, pertinent to the US and to Australia as much as to the UK, is that variable investment returns can result in considerable uncertainty of income in retirement and of the age at which pension savings run out for retirees choosing income drawdown.

Because the UK still has a significant number of means-tested benefits, including assistance paid to retirees to help them with their rent (housing benefit) and to reduce their tax bills (council tax reduction), the decumulation behavior of retirees may also affect how much the government must expend on means-tested benefits. For instance, modeling in our report showed that if those with reasonable-sized pension pots (over £100,000) spent their savings quickly, then the government would end up spending out more on means-tested benefits on these individuals than had these individuals spent their savings gradually or bought an annuity.

The US has been running a deregulated decumulation phase for some years. Some voices have been raising concerns, including the AARP’s David John. Just last year, the Australian government accepted the recommendations of its Financial System Inquiry (also called the Murray Inquiry), which argued for pension schemes to run default retirement paths that include elements of guaranteed income for life alongside some more flexible elements. Our principal recommendation was for an “early warning system” that could provide the UK government and regulators with information and insights into consumer behavior, thus enabling emerging risks to be identified promptly.

More broadly, it is an area where the international research and policy community must continue to collaborate and share lessons and ideas.

 


about the author

Nigel Keohane is research director of the Social Market Foundation (SMF), an independent think tank based in London. He leads the SMF’s work on savings, pensions, aging, and retirement. Previously, he worked in local government and taught history at the University of London. He has a BA and MA in history and a PhD in political history.

 
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