In its pension freedoms review, the Work and Pensions Committee called on providers to offer a default pension drawdown option.
While this may seem a sensible development following on from the compulsory defaults in auto-enrolment for pension accumulation, I have to say I have many reservations.
When we begin to save for a pension, the objective is to build a fund of money that can finance retirement spending. At the beginning of adulthood, we do not know what the future will bring. We could be singing a modern version of the Doris Day song, ‘Que sera sera’. Will I be rich? Will I be poor? Will I own my home? Will I marry, if so how many times? Will I divorce? Will I have children? Will I have relatives to support and care for? Will I be healthy?
The answers to the above questions will become clearer as adulthood progresses. Younger adults only have to concern themselves with one issue, they need to save for their retirement, whenever that may be and whatever it will be like.
Therefore default accumulation funds in auto-enrolment schemes have a place and are successful. It is believed that over 90% of members are in default funds.
This is understandable, most are just putting money aside for a distant, unknowable future where they will have to call on their savings but to be honest they have little idea how much savings they will need, or who they will be supporting. A regulated low-cost investment vehicle is just what they require but what they get is a default fund.
I see the journey through adulthood being the shape of a cornet. In the beginning, we are at the point with the greatest diameter, where most of life’s possibilities could arise. As retirement approaches due to events and personal circumstances the number of possibilities will dramatically reduce; the diameter of the cornet is therefore much smaller.
‘Default drawdown cannot work’
This is one reason why a default drawdown product cannot work. Two people of the same age with totally different retirement possibilities in the same default drawdown product – one is going to be in the wrong product.
Now, look at how people transition into retirement. One may be single and retire several years before state pension age. Another may work part-time beyond state pension age and be married to a much younger working partner.
Their ‘retirement’ spending patterns, particularly in the crucial first period of retirement, will be much different. The former will need to front-load their retirement income to maintain their spending patterns until their state pension kicks in. The latter may have additional income streams after state pension age in addition to the employment income they are receiving and need to make next to no drawings on their pension.
Retirement wealth is not restricted to their defined contribution (DC) pension pot within the scheme in question. They may have sufficient defined benefit (DB) pension income with a small DC pension in which case they may decide to use the DC pension as a retirement reserve, to be used for emergencies or special treats. Regular income from their DC pension is not a requirement.
What income will a default drawdown fund produce? We cannot use Bengen’s 4% safe withdrawal rate in the UK, it is based on historical US investment returns. Morningstar have suggested the UK equivalent would be 2.85%. This would produce an inflation-proofed income with a 90% certainty of not running out of money for 30 years. There will be risks for those who live longer than 30 years and for those where the sequence of returns in the early years of retirement would not sustain for 30 years. In any event would the income on offer drive people towards level annuities? It was the criticisms of annuities that made Pensions Freedoms an expedient policy.
An increasing number of retirees use their housing wealth to fund their retirement spending. Downsizing occurs for two reasons to release funds to help fund retirement spending, or because the house has become too large or difficult to maintain.
The former is likely to occur earlier in retirement. This will create another drawdown fund alongside the pension fund. How should they both be used? If used sequentially, in which order? Or should they be used in tandem? These decisions could affect the investment strategy and the withdrawals from the pension drawdown fund making a default inappropriate.
Equity release is currently more likely to be used well into retirement usually when pension savings are becoming depleted. If someone has a default drawdown income which is insufficient will they turn to equity release earlier? Will the default product determining behaviour rather than behaviour dictating the product requirement?
This all begs the question, who will the default pension drawdown product be designed for? What will prevent those it will be inappropriate for from using it?
As we progress through the cornet of adulthood our circumstances become more individual.
This is what makes retirement income planning so interesting. The components are there to enable an informed individual to meet their personal retirement needs. We need an infrastructure of guidance and advice that helps match the individual to the components they require, rather than default products that may be totally inappropriate for some.
Bob Champion is chairman of the Later Life Academy