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25 Jul 2022
by Stephen Lowe

Why employees need independent advice before deciding what to do with their pension freedoms

Despite initial fears of pensioners splurging cash on luxury goods, the bigger concern is that those who choose drawdown will still run out of money

Why employees need independent advice before deciding what to do with their new pension freedoms.jpg 1

 

Lamborghini dealers probably haven’t experienced a significant uptick in sales since the introduction of pension freedoms. The same is probably true for other sellers of luxury items, despite all the hype about the new pension freedoms leading to pensioners splurging their cash.

Is  this evidence of a balanced response to the risks posed or are we looking in the wrong place?

Around 350,000 funds were encashed last year. Of these, over 300,000 were for sums worth less than £30,000 and more than 200,000 were for sums less than £10,000, according to the FCA. At these levels, some commentators may say there is less cause for concern – these amounts would barely cover the deposit on a luxury sports car. They may form just a small proportion of someone’s overall pension wealth.

Though few people are encashing large pension funds, a perfect storm is forming elsewhere.

Pushing the limits

Before pension freedoms most people used their defined contribution fund to buy a guaranteed income for life, usually an annuity. Of those who chose drawdown there were safeguards: Limits on the maximum income they could take and, to all intents and purposes, a requirement to annuitise at age 75. Now we have unfettered drawdown. People can take what they want, when they want. This gives rise to three main concerns.

Firstly, more people are choosing drawdown. Drawdown sales are nearly three times the level of annuity sales. This could be a result of people making informed decisions after considering all of the pros and cons. But could it have more to do with comments such as that by the then Chancellor of the Exchequer that ”no one will have to buy an annuity”. Remarks like these often lead people use to make decisions quickly without considering all the information.

Buying without advice

Secondly, there are significant numbers of people buying drawdown without advice. The latest data suggests that around 40% of new drawdown plans were sold without regulated advice, according to the FCA. Drawdown is a complicated product which requires oversight and management. Longevity, investment strategy, capacity and attitude to loss, legacy objectives and much more all need to be carefully considered.

The third element is perhaps the most worrying.

The latest FCA data suggests that withdrawal rates are simply too high and likely to prove unsustainable and the current cost of living crisis will add further upward pressure to these levels. Significant numbers of retirees could run out of money during their retirement. The most popular withdrawal rate is 8% or more. By any analysis, withdrawal rates at this level are unlikely to last a lifetime. At the same time, the FCA data should be treated with care. The highest withdrawal rates are for smaller funds, which could be incidental to someone’s main retirement provision – but, back to my data comment earlier – we don’t know that for sure. In comparison, withdrawal rates are much lower, on average, for larger funds where the funds may represent the bulk of a retirees pension pot.

But even for larger funds, the figures give rise for concern. For funds between £100k – 249k around two thirds are taking 4% or more. Of these, nearly one-third are taking 8% or more.  People with funds over £250,000 are withdrawing at lower rates, on average, but around one-third are withdrawing 6% or more. Again, there may be legitimate reasons. We don’t know what other assets someone may have or if they have material health impairments.

Unsustainable rates of withdrawal

Despite these mitigations, it’s difficult not to conclude that these rates are worrying. The general rule established by William P Bengen is that 4% is a safe, sustainable withdrawal rate but even this has been challenged. Bengen’s analysis ignored charges. In the UK, there are often a series of costs: platform charges, cost of advice, investment fees. These can have a significant impact. The Bengen study used US stock indices, which have historically outperformed the UK. And many commentators have argued that, in today’s low bond yield environment, 4% may simply be too high. Overall, the weight of opinion suggests that a figure nearer 3% or lower may be more appropriate.

Running out of money has never been an issue for UK retirees. The bedrock of retirement planning – State Pension, final salary pensions and annuities all guaranteed an income for life. Even drawdown, when first introduced, came with important safeguards.

Rising life expectancy

We are entering a new phase of retirement. The challenge of providing a lifetime income against the backdrop of rising life expectancy is challenging. It requires expert help and advice. More and more schemes recognise the need to support people as they transition to retirement, but many schemes have been reluctant to act or are uncertain how to respond.

The government recently introduced the stronger nudge. This is a welcome initiative, but it’s not a panacea. There is much more that can be done to help employees and pension scheme members achieve better outcomes during retirement.

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