The secret to happiness is freedom, wrote the ancient Greek historian Thucydides. But many UK pensioners are finding the freedom to do as they wish with their savings is not quite delivering the happiness they had hoped for.
Since rules governing how pensions can be taken were dramatically relaxed in 2015, more than a million over-55s have gone on a freedom-fuelled spending spree. More than £23bn has been “cashed out” from the nation’s pension pots via more than 5m individual payments.
Research suggests that much of this cash has been spent paying down debt, renovating homes, upgrading cars or helping adult children on to the property ladder.
But freedom is coming at a high price for many less experienced investors struggling to make good decisions in a complicated market, fraught with unscrupulous advisers, tax tripwires and opaque fee structures — causing their retirement funds to dwindle.
The situation has been exacerbated by a regulator playing catch up to make the market safer for consumers, after the changes were enacted with very little warning, leading some experts to brand pension freedoms a “policy car crash”.
Here, FT Money examines the unintended consequences of the reforms and the areas of the market where consumers deserve to be better protected.
The rise of the DIY investor
The “pension freedom” reforms of 2015 were warmly welcomed by consumers, as they vastly widened options available to most UK savers at retirement.
Before this, tax restrictions ensured that most of the 400,000 people retiring each year were shunted into annuities — products sold by insurers which turn a pension pot into a secure retirement income for life. In the wake of the financial crisis, these had become poor value as looser monetary policy drove annuity rates to record lows.
“Let me be clear. No one will have to buy an annuity,” declared George Osborne, the former chancellor, when he unveiled the biggest changes to pensions in decades in his 2014 Budget.
The overhaul, rolled out a year later, gave millions of savers aged 55 and over access to their “defined contribution” pensions pots, typically worth £50,000 or less. They now had access to more flexible, but riskier, pension products which hitherto had been largely restricted to more sophisticated, wealthier investors who acted with the help of an adviser.
“Drawdown” products are so-called because retirement funds remain invested in the stock market, with the saver drawing down an income. The investment exposure means they are considered riskier than an annuity. But this is not the only downside — an array of charges can hit returns, and if growth does not pan out as planned, there is a real risk of funds running out earlier than expected.
Since the introduction of pension freedoms, there has been a massive swing to “DIY” drawdown. One in three pensioners are now going into drawdown without the help of professional adviser, compared with one in 20 before the overhaul according to the Financial Conduct Authority. It is here that experts say many are tripping up.
“The freedoms put a greater onus on individuals to be well informed as they are required to make more complicated choices about their retirement, including important decisions on how to invest their pensions pots, when to take their income and the need to consider longevity risks, or how long they need to make their money last,” says Malcolm McLean, senior consultant with Barnett Waddingham a pension industry adviser.
“But in the face of so much choice, many people are making mistakes and finding out the hard way.”
Making a mistake with your pension later in life can be financially catastrophic. For most, it will be too late to earn the money back. So the challenge for regulators has been to weigh the impact of freedoms and greater individual choice against protecting consumers from financial harm.
The dash for cash
Nearly five years after the freedoms were announced, the Financial Conduct Authority (FCA) unveiled a package of major interventions to make the market safer after a two-year review found evidence that savers — acting without guidance or professional advice — were struggling to make good decisions as they dashed for their cash.
The most serious trend to emerge has been the sharp rise in scams, where fraudsters and rogue advisers lure savers into investing their life savings into high- risk or unsuitable investments.
In 2018, an estimated £200m was lost to pension scams, with affected savers losing £91,000 each on average. But a number of other serious problems have also emerged, including savers being enticed out of gold-plated “final salary” pensions by rogue advisers, in part lured by the flexibility of pension freedoms.
Commentators have also criticised poor transparency in drawdown products, leaving investors at risk of being ripped off by high fees or defaulting into unsuitable funds, including leaving their funds to languish in low-interest cash accounts. Many are bamboozled by choice and have no easy way to compare different products.
Meanwhile, providers of traditional annuities have been leaving the market as demand for these has softened in favour of drawdown. By contrast, pension freedoms have brought some happiness to the Treasury; its coffers are expected be boosted by £5bn by savers paying tax on pension withdrawals, often at unexpectedly high rates (see sidebar).
FCA’s proposals to fix the pension freedom market
- Providers that offer drawdown without advice will be required to offer “investment pathways” designed to help savers make appropriate retirement choices.
- Anyone investing 50 per cent or more of their pension in cash will need to make an active decision to do so
- Retirement communications will be given a shake-up, with consumers receiving a simple one-page summary document at age 50 by November this year
- Drawdown sales documents to present charges in pounds and pence from April 2020
The regulator plays catch up
Grilled by MPs this month on why they hadn’t acted faster to head off these problems, the City watchdog’s top officials made the frank admission that they had been on the back foot since the reforms were announced without warning in 2014.
“I think the pension freedoms were a sensible thing to do in the context of the changing patterns of working, the change in longevity and the need for flexibility,” Andrew Bailey, chief executive of the Financial Conduct Authority, told the work and pensions select committee.
“However, when I look at many of the things that we are doing . . . in a broad sense we are putting in place the framework for helping people to use the freedoms after they have been put in place.”
His admission did not go unnoticed by market observers who had witnessed the biggest changes to pension tax rules rushed through at breakneck speed in the space of 12 months.
At that time, some — including a former senior adviser to the government — suspected that the chancellor’s chief motivation was to boost tax revenues as the over-55s rushed to cash in pensions, paying tax on withdrawals beyond the 25 per cent tax-free lump sum.
“Government departments and regulatory authorities were handed a real hot potato when the Treasury introduced pension freedoms with almost no forewarning,” says Jon Greer, head of retirement policy at Quilter, the wealth manager.
“While the reforms have been hugely popular, there are some issues of real concern that could damage the legacy and credibility of the freedom and choice reforms. The continual knock-on impacts of pension freedoms are revealing that parts of the current regulation and legislation are no longer fit for purpose.”
George Osborne, now editor of the Evening Standard, did not respond to a request for comment.
In a policy document published in September 2018, the FCA conceded that freedoms had “transferred the responsibility for a very complex area of decision-making to individuals, and we need to do all we can to help people make those decisions”.
When pressed by MPs this month as to what they were doing about fraud and other problems, such as pension providers trying to incentivise customers not to take advice, Christopher Woolard, the FCA’s executive director of strategy and competition, said: “This is an area where, frankly, the rules of the game are playing catch up with the freedoms, to some extent.”
Hugh Pemberton, professor of contemporary British history at the University of Bristol, says lessons have not been learned from previous pension scandals.
“Regulation is never sufficient, so we are constantly playing catch up,” he says.
“We are always banging up against in the same problem in pensions . . . individuals are not very well informed and are not necessarily rational about their pension savings. Now, we have the risk over the long term that people will both run out of money, but also underspend because they are being too cautious. It is a policy car crash.”
Where to turn to for advice is a major issue. The government initially promised that all over-55s with DC pension pots would be eligible for free pensions “advice” through its Pension Wise service; only later to dilute this to “guidance”.
Obtaining individually tailored advice from an independent financial adviser can cost thousands of pounds — something that only the wealthiest are prepared to pay for — increasing the vulnerability of moderate savers.
Calls out of the blue offering a “free pension review” have been a frequent entry point for fraudsters. Although the government has banned pensions cold calling, it is powerless to stop rogue investment companies cold calling individuals from overseas.
Sir Steve Webb, pensions minister at the time freedoms were rolled out in 2015, defended the coalition government’s handling of the reforms.
“If the government had announced pension freedoms in 2014 but with implementation delayed to 2016 there would have been mayhem with two years of limbo in the annuity market,” he says.
“Sometimes there is a case, within reason, for getting on with things, putting in place the key regulatory regime, but recognising that it will evolve.”
However, critics argue this evolution is not happening quickly enough.
Sir Steve, now director of policy with Royal London, a pension provider, adds that it is “vitally important” to remember the consumer detriment that was happening every day before pension freedoms when most people were forced to buy a poor-value annuity.
“Many of these people got better outcomes because of pension freedoms, but they don’t make the headlines,” he says.
But Prof Pemberton disputes whether pensioners are now in a much better position, noting the FCA’s evidence of weak competition in the drawdown market, a factor not helped by low rates of shopping around.
“The problems of the old annuity market are surfacing in the drawdown market but this time they are at risk from high charges, not poor value annuities,” he adds.
While debate remains charged about the price of freedom over the longer term, Sir Steve maintains the reforms were the right thing to do.
“If philosophically one objects to freedom because of the risk of people making poor choices, that is a legitimate position — although not one I share,” he says.
“But if you are in favour of freedom, then you will never have a system that 100 per cent protects people from the consequences of their own actions.”
Five traps of pension freedoms
From tax traps to scammers, pension freedoms have exposed investors to a range of new risks.
1. Paying too much tax
Since freedoms were introduced in 2015, more than 170,000 savers have been overtaxed to the tune of £400m due to the inflexibility of the tax system.
Under current rules, beyond the typical tax-free lump sum, pension withdrawals are taxed at an individual’s marginal rate. However, when a lump sum is first taken from a defined contribution pot, HM Revenue & Customs requires pension providers to apply a temporary tax rate — which can often put savers into a higher tax bracket. This could result in individuals paying thousands of pounds more in tax than they should. The saver will then need to reclaim the overpaid tax from HMRC.
In a separate tax trap, almost 1m over-55s risk receiving unexpected tax bills after dipping too deeply into their retirement funds; the most common way of triggering the Money Purchase Annual Allowance (MPAA) which slashes the annual allowance from £40,000 to just £4,000.
2. Bonanza for scammers
Easier access to pensions cash has proved a bonanza for fraudsters. Last year, the over-55s were hoodwinked out of an estimated £200m by pension scammers. However, industry experts believe up to £1bn of pensions fraud has been committed in the past decade, as not all of it is reported.
Scammers typically use tactics such as cold calling individuals and offering them a free pension review. Savers are enticed to invest their life savings in high-risk or unsuitable assets offering returns that are too good to be true. A ban on pensions cold calling came into force in January, but this was too late to help many victims.
3. Pension transfer mis-selling
Pension freedoms have opened up new opportunities for savers to give up their generous final salary-style pensions for eye-watering lump sums.
The regulator believes giving up a defined benefit pension, which pays a secure income for life based on salary and length of service, is not the best route for most people. But thousands of savers may have been badly advised to trade their valuable benefits for a cash lump sum today, and transfer it to a riskier DC pension where the funds can often be invested in high-charging and unsuitable assets.
In a recent review by the regulator, fewer than half of transfers were deemed sound enough to have proceeded. Experts now believe a new pension transfer mis-selling crisis is unfolding.
4. Poor deals for drawdown investors
The Financial Conduct Authority has found that consumers acting without the help of an adviser are at greater risk of poor deals. According to the FCA’s analysis, nine in 10 investors who went into drawdown without the help of an adviser chose the path of least resistance and took the deal offered by their existing savings provider, compared with 35 per cent of advised customers.
Given this lack of competitive pressure, the FCA said it was concerned that consumers might pay too much in charges. Its analysis found that charges for non-advised drawdown consumers varied from 0.4 per cent to 1.6 per cent between providers. By switching from a higher cost provider to a lower cost provider, consumers could increase their annual income by 13 per cent, the FCA found.
5. Cash trap
The FCA found some drawdown providers were “defaulting” consumers into cash or cash-like assets. Overall, a third of non-advised drawdown consumers were wholly holding cash. Holding funds in cash may be suited to consumers planning to draw down their entire pot over a short period. But it is highly unlikely to be suited for someone planning to be invested over a longer period, who will be losing out on valuable retirement income. FCA analysis found that 33 per cent of consumers who do not take advice held their whole drawdown pot in cash accounts or exclusively in “cash-like” funds.
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