The new pension rules being introduced on 6th April are likely to be hugely popular with both the pensions industry and with pension investors, many of whom welcome the greater freedom which they bring.
However, the government is rushing these reforms over a very tight schedule ahead of the general election in May. With such radical change being introduced so rapidly, things could go wrong. Hargreaves Lansdown has identified the top ten risks presented by the new reforms, as well as some thoughts about what can be done about them.
Fraudulent investment schemes targeted at the over 55s
This is seen as probably the biggest risk, in terms of potential consumer loss and worryingly it is one the government has done precious little to address. Pension fraudsters have already ‘liberated’ hundreds of millions of pounds of pension fund money in recent years, using scam pension schemes.
From 6 April they won’t need to set up scam pensions anymore because they can simply target the over 55s with seductive offers of ‘too good to be true’ ‘guaranteed’ investment schemes.
This is likely to be a long term problem for everyone involved in helping individuals to build a secure retirement. The government should be working with the industry and regulators to create a more robust distinction between regulated and unregulated investment arrangements.
Unexpected tax bills
Recent studies have confirmed that the majority of pension investors do not fully understand how the tax treatment of pension fund withdrawals will work. Once the cash has been withdrawn from a pension and the tax has been paid (deducted by the pension provider before the money is handed to the investor), it will be too late. The pension providers will be required to alert investors to the fact that tax will be deducted however even now, with just 12 weeks to go no formal guidance has been issued on how pension providers should actually go about this.
In the meantime, pension providers, the Pension wise service and the media must do everything possible to publicise the potential tax consequences of early pension fund withdrawals.
Final salary scheme members transferring to defined contribution schemes
It is understandable that some scheme members may want to exchange their defined benefit pension for a flexible defined contribution pot of money. The government has imposed a requirement that any transfer values in excess of £30,000 must first be subject to independent financial advice on the suitability of the transfer.
Inevitably some scheme members will be seduced by the short term appeal of ready cash in preference to the longer term and less ‘tangible’ benefit of a guaranteed lifetime income. For some this may be a logical financial or life planning decision however it is also a decision that some may come to regret later in their retirement if the cash runs out.
The Pensions Regulator should be taking a robust approach with Defined Benefit scheme trustees who may not be offering their members transfer values which represent fair value for the benefits in the scheme which they are contemplating foregoing.
Investors’ pension pots run out too soon
Almost inevitably some pension investors will run down their pension pots before they die. If this happens deliberately and with forward planning then that’s fine but it probably won’t always be the case, for the following reasons:
- Underestimation of life expectancy
Investors typically underestimate their life expectancy by several years; it is in any event extremely hard to predict.
- Capital withdrawal in market downturns
A falling market can do a lot of damage very quickly. For example, if you are drawing 6% a year income from a pension pot and it falls by 20% in value in year 1 before then growing by 4% for the next 9 years, at the end of the 10 years, it will be worth less than half what you started with. In 20 years it will all be gone.
- Investment returns fail to meet expectations
Some investors can be over-optimistic about investment returns, hoping to enjoy strong equity type returns every year but this isn’t going to happen (not without taking some stomach-churning risks anyway). If the markets just fail to grow fast enough, then investors may end up ruing the decision not to buy an annuity.
The FCA’s new ‘Second line of defence’ requirements for pension providers may help to protect investors from the complexities of drawdown.
Overestimating state benefits
Over the first 5 years of the new state pension, just 45% of new pensioners will qualify for at least the full new state pension. Even by 2025, less than 2/3rds will be getting the full amount. Other aspects of state benefits, such as the help which can be expected in paying for later life care costs are also still poorly understood.
The risk with the new pension freedoms is that investors may have unrealistic expectations of the level of state support they can expect in the event that they run down their private savings. By the time they find out, it may be too late.
It is imperative that as soon as possible, the DWP is able to provide anyone who needs it with an accurate projection of their state pension entitlement. Anyone contemplating drawing on their private savings before state pension age should make sure they have verified their state pension benefits.
Pension guidance service unable to cope with demand
In the short term, the Pension wise service is aiming for a Goldilocks result: not too much demand but not too little either. If no one takes it up, this will be both disappointing for the government which designed it (and the pensions industry which has paid for it) and risky for investors, who may not be getting the guidance they need. If demand is too great then the service could be swamped.
Given the relatively low numbers of trained staff available to give the guidance, and the huge uncertainty over how many people will seek guidance in the first weeks and months, the chances of hitting that Goldilocks outcome must be low.
In the longer term, the Pension wise service will no doubt settle into an equilibrium, with resources matching demand; however it may have to live with the reputational damage of having got it wrong in the critical opening phase.
Investors buy poor value annuities
Despite the best efforts of advisers and retirement brokers, the media and policymakers, a substantial minority of retiring investors have consistently failed to shop around for the best deal when buying an annuity. This has had the direct consequence of costing them money in retirement.
The FCA is now looking at measures such as requiring annuity providers to publish comparative data on the competitiveness of their terms and this may help. They are also looking at ways to improve the retirement communications sent to investors in the run up to retirement.
These measures should help but because of the tight political timetable imposed by the government, it is unrealistic to expect these regulatory measures to all be in place by 6th April. As a consequence, the first wave of retiring investors may have the dubious privilege of having to act as guinea-pigs for everyone who comes after.
The FCA work on improving retirement communications should be supported by all industry participants and should be developed as quickly as possible.
Pension schemes may not be ready in time
Ironically, the thing which might protect some investors is the fact that pension providers are being asked to do so much in such a short space of time that many will probably not be ready in time. There is mounting concern within the pensions industry that when the phones start ringing on Tuesday 7th April (after Easter Monday), many pension scheme members are going to be met by some fairly chaotic responses.
Any investor who has earmarked their pension fund for withdrawal in April, or for specific spending plans, would be well advised to contact their pension provider now just to check what they may or may not be able to do.
Pension investors don’t draw their money quickly enough
Just as pension investors may inadvertently draw down on their retirement savings too quickly and end up running out of money, they also run the risk of being too conservative in retirement. Living too frugal a life in retirement and ending up with undrawn funds could be just as bad as spending the money too quickly.
The best tool to avoid such an outcome would be to buy an annuity, which is a very efficient mechanism for smoothing retirement income across the full duration of retirement. Unfortunately the annuity brand has become toxified by negative publicity so some investors who probably should buy an annuity may avoid them and then end up not spending money which they could have used in retirement.
Investors should not dismiss the merits of buying an annuity. A comprehensive shopping around process, taking in fully underwritten annuities, drawdown and a combination of different options is the best approach for most investors.
Pension investors withdraw money unnecessarily
Finally, it is anticipated that some pension investors may choose to dip into their pension pot when they could use money from elsewhere. A pension fund grows largely exempt from tax so it is a good place to hold money until you need it. In surveys, a minority of investors have even indicated that they plan to take money out of their pensions simply to save it in the bank. Others will use it for short term capital expenditure.
Given that these funds have been painstakingly accumulated over decades for the express purpose of providing a retirement income, investors are being urged to think twice before making withdrawals ahead of retirement.