Mark Hoban is a former Financial Secretary to the Treasury and Employment Minister, and is MP for Fareham.
The principles and politics of the Chancellor’s pensions reforms have been extensively picked over since the Budget. The reforms are right in principle and, as last weekend’s opinion polls show, politically very powerful. They also respond to the prospect that today’s low returns on savings will continue for some time. Whilst quantitative easing has been blamed for many of the ills of the savings market, the truth is that low returns are here to stay. The measures in the Budget will help offset these low returns, but to capture fully their benefits, further reforms are needed.
Earlier this month, David Miles, a member of the Monetary Policy Committee, forecast that the new normal for interest rates would be 2.5 per cent, not the pre-recession normal of 5 per cent. At this new level savers would struggle to make a decent return on the savings. The decline in interest rates will be partially offset by the significant hike in ISA limits, the abolition of the 10 pence starting rate and the launch of the Pensioner Bond.
The plight of savers has also been exacerbated by the fall in annuity rates from 15 per cent 20 years ago to 6 per cent today. Lower inflation and thus lower interest rates have driven annuity rates down, but this has been compounded by an increase in life expectancy. In 1990, a man aged 65 was expected to live until 79; by 2010, this had increased to 83. With life expectancy forecast to rise, annuity rates will continue to fall as insurers are providing incomes for longer. Greater freedoms over annuitisation give people the chance to use their pension savings in a way that they think will maximise their income.
In the short term, the benefits of the Chancellor’s reforms are clear as they will help people maximise income from their existing savings. To ensure the reforms have long term benefits, we have to tackle three issues – products, advice and pension contributions.
No one knows how the savings market will develop to take advantage of the new freedoms that pensioners will have. Whilst annuity providers saw their shares fall on Budget Day, it would be wrong to assume that there will not be a market for annuities in the future. In looking at our retirement choices, the greatest unknown is how long we will live for. If we knew the answer, then we could decide how quickly to spend our pension savings. Too quickly and we run out of money before we die, too slowly and our families will inherit more than they expected. Annuities answer part of that question by insuring you against running out of money before you die. You might not like how much you are getting but you know that you will always get it.
I think the security offered by annuities will be valued by many even with the new freedoms. Today, pensions savings rollover automatically into annuities, pension providers will now be thinking about the new products that people will switch into when they retire. Policymakers and regulators need to make sure that new products represent better value than annuities and the market works in the interests of consumers. We don’t want the problems that bedevil the sale of annuities to resurface in products designed today.
People who built up a pension pot should be free to use it in the way that suits them best. Giving people the right to choose is good, but we need to help them exercise that right. We should not forget that one of the reasons why the annuities market malfunctioned was that too few people shopped around for a better deal. We also know from behavioural economics that, when confronted with too much choice, people simply go for the easiest option. In this case they might simply opt to leave their savings with their existing pensions provider and roll over into whatever replaces annuities as the default product. People will want some form of advice and support about how to make the most of their new freedoms.
The Government has offered the right to guidance, which will be a conversation about pension choices. Whilst this might be enough for the financially savvy or those with small pension pots where cashing them in is the obvious answer, it is unlikely to be the right answer for those who have moderate pension savings but are not served by independent financial advisers. We need a new digital advice service that meets the needs of the mass affluent who need more than just guidance but don’t need the full service of an IFA. In developing this, we should be building on the work of the Money Advice Service and The Pensions Advisory Service.
Better products and a step-change in advice will help people make the most of their existing savings. Our reforms will mitigate the impact of low returns on savings, but we also need to look at the other factor drives retirement income – how much we have saved. As an excellent report from Policy Exchange pointed out recently, too few people are saving enough to provide a decent income in retirement. Whilst auto-enrolment means that millions of people will be saving towards their pensions for the first time, the contribution rate of eight per cent isn’t enough in itself to allow someone to build up a pot that will provide an adequate income in retirement. Whether through exhortation or compulsion the contributions rate will have to rise so that people have a decent sized pension pot that will enable them to exercise the new freedoms.
One way the Government can help is to look at the tax relief it provides on pension contributions. In 2011/12, tax relief on pension contributions cost the taxpayer £28.1 billion. By comparison, the cost to the Government of completing the rollout of auto-enrolment is estimated to be between £1.1 and £1.8 billion. The structure of tax relief on pension contributions is currently biased towards people on high incomes who not only pay tax at a higher rate but also have higher pension contribution rates. The structure does not help those on lower incomes whose pension contributions are a bigger sacrifice. We should redesign the structure of pensions tax relief to reward those on low incomes who do the right thing by saving for their retirement. For example, should we equalise the rate of pensions tax relief at 30 per cent rather than 20, 40 or 45 per cent depending on income? We should be exploring different ways of encouraging those on low incomes to increase their pension contributions to provide them with greater security in old age.
The introduction of the single tier pension provides the platform for the radical reforms the Chancellor announced last week. The single tier pension allows us to move away from a paternalistic and self-interested Government telling people how to use their pension savings to avoid them becoming reliant on means tested benefits. But we can’t allow the new freedoms to perpetuate the old failings of the pensions market. We need consumer friendly products, an advice service for the 21st century and new incentives for those on low incomes to have financial security in old age. In this way, we will see these new freedoms provide a better retirement for all.