The latent costs of Osborne's pension overhaul
“No caps. No drawdown limits. Let me be clear. No one will have to buy an annuity."
Osborne's budget announcement
On 19 March 2014, Chancellor George Osborne announced his plan to reform the UK pension model. No longer will retirees be forced to purchase an annuity with their pension fund; they are now at liberty to manage their own finances, and seek alternative ways of generating an income in their retirement.
Many celebrated this as a victory for consumers and liberalism. The Daily Express ran the headline "Joy for all"; the Daily Mail declared "victory" in the campaign against the "great pensions rip-off"; and even the Guardian acknowledged that this was a "dramatic liberalisation of Britain's pension system".
However, whilst the reforms undoubtedly appeal to the grey-vote (and will likely initially generate a large amount of tax to tackle the deficit) there is a latent sting in the tail for those of typical trainee age.
What is an annuity?
An annuity is an insurance and investment policy which, in return for a single premium, provides the insured or consumer with a guaranteed and regular income for the duration of the insured's life. The amount of income provided by the annuity will depend on a number of factors: some are specific to the insured and others are more specific to the underlying investment conditions at the time the policy is taken out. Factors specific to the insured may include:
• The age of the insured (the older the consumer, the lower the purchase price than for comparable benefits with a younger person;
• The health of the insured (a number of insurers are able to offer better rates to individuals with a shorter anticipated life expectancy); and
• The type of income required (for example, if the insured desires an escalating income instead of a fixed income it would be reasonable for the purchase price (premium) for the annuity to be higher).
The benefit of purchasing an annuity is that it provides retirees with the security of a guaranteed income for the remainder of their lives.
Until April 2015 retirees are able to receive 25% of their pension pot as a tax-free lump sum but are required to purchase an annuity with the remaining 75%. Osborne's announcement has removed the obligation to purchase an annuity thus allowing retirees access to their entire pension pot. However, any money removed from the pension pot will be taxed at the relevant income tax rate of the retiree.
In the short term this will result in a massive windfall in tax for the government, and will no doubt provide a nice injection to the balance sheet ahead of the next General Election.
What does this mean for imminent retirees?
Osborne's reform offers pensioners the choice as to whether to purchase an annuity, or invest their money elsewhere. This may include investments such as share portfolios (which pay income to the shareholder by way of dividends) and buy-to-let property (which can generate rental yield). Alternatively, pensioners may choose to simply "draw down" from the capital in their pension pot, and hope it doesn’t run out before they do!
In the event that a pensioner's savings prove insufficient to support them, however, they will require state support for income, health, housing and care.
What does this mean for the insurance industry?
Osborne's announcement was disastrous for the insurance industry. The share value of UK insurers fell by £3billion following the announcement, with insurance giants Legal & General and Aviva's share prices falling 8.4% and 5.2%, respectively. Specialist annuity providers suffered even greater losses with Just Retirement and Partnership Assurance's share prices each falling over 40% in a day.
In the absence of any legal compulsion to purchase an annuity, the market feared that insurers would lose a significant proportion of their customer base and that their revenue would suffer as a result. If one considers Australia's pension experience, the market's concerns appear well-founded. In Australia, where pensioners have the choice of how to fund their pension, only 4% choose to purchase an annuity on retirement.
Why should this interest me?
Osborne's pension reform appears to be a final parting gift to the charmed baby-boomer generation. There is no doubt that the reform will be well received by both those approaching retirement, and those of a certain ideological persuasion. It is also very likely that the overhaul will be presented as a triumph in the build-up to next year's General Election.
What is less clear is how Osborne's "bonfire of the annuities" will affect our generation. The Office of National Statistics estimates that the ratio between those of working age and those of pensionable age will decrease from the current figure of 3.13, to 2.61 by 2035. This will place an increased strain on taxpayers to maintain the existing state pension, healthcare and care home infrastructure. If Australia's pension experience provides an insight into the UK's pension future, many pensioners will choose to fund their retirement without annuities, and many of those will later appreciate that their pension pots are insufficient.
Once a pensioner cannot afford to fund their own retirement, they become reliant upon the state for their welfare needs. The glory of annuities is that they limit the state's exposure to the welfare needs of retirees as the risk is absorbed by the private sector. By guaranteeing a regular income, annuities prevent retirees from emptying their pension pots. If pensioners turn their backs on annuities en masse, there is a good chance that more pensioners will end up being entirely dependent on the state for their retirement needs.
Often pensioners don't (and won't) rely on the state during their retirement – prudent financial planning and/or the purchase of annuities makes many retirees self-sufficient. However, a large percentage of pensioners are entirely dependent on the welfare state. The danger of Osborne's announcement is that those who would have otherwise purchased an annuity and ensured their self-sufficiency may well be tempted to invest their money in more risky ventures, or simply choose to draw down on their pension pot. In the event that investments suffer and/or individuals outlive their savings, the state will "foot the bill" for the remainder of the individual's retirement.
Even if only 10% of retirees mismanage their pensions, the resulting burden on the taxpayer will be considerable. It will be far greater than any short-term gains received by the Treasury in tax over the next few years.
There is a further blow to the current trainee solicitor generation: it is likely that many retirees will now consider putting their non-annuitised pension sums towards buy-to-let property as an alternative way of guaranteeing a regular income. This will result in retirees re-entering the property market at a level usually reserved for first-time buyers. The corresponding increase in demand for property of this nature will result in further escalation of property prices, and those who cannot afford to buy homes (not least because of the income tax increases that will be necessary to prop up the ageing population) will also have to pay crippling sums in rent to subsidise the pensions of those who would otherwise have purchased an annuity.
Will Jones