PENSIONSANDSAVINGS.COM

• Ongoing interest rate rises confirm the value of pension freedoms. 
• Reforms have saved millions of pensioners from locking into record low annuity rates, without inflation protection or spouse cover. 
• As QE comes to an end, annuity rates have already increased as inflation and interest rates have risen. 
• Pension providers have a chance to redesign pensions and move on from one-size-fits-all thinking, with wider investment options and new ways of preserving spending power for later life.   

Rising rates and inflation expose the dangers of annuity purchase when central banks are printing money to buy bonds: As interest rates seem set to stay higher for longer than previously thought, the plight of pensioners who locked into annuities in recent years has so far been ignored. Many of those people who took advantage of the so-called pension freedom reforms introduced in 2016 have been spared the need to buy annuities at record low rates, which would leave them poorer and without any inflation protection for the rest of their lives. Around half a million people each year were at risk of having to annuitise, against the background of ongoing Quantitative Easing policies that deliberately drove down long-term interest rates.  As long rates fall, annuity costs rise and pensioners swapping their pension pot for a lifetime income receive much less for ever.

Annuity purchase was high risk and poor value for many, but consumers did not know: Before 2016, pension firms were permitted to require their customers to buy an annuity with their pension fund to provide a retirement income.  Unless people had a very small or very large fund, they were forced to annuitise. And there was no proper customer help to find the right type of annuity, there was no transparency on the risk margins or profit margins that insurers were pricing into the products, so that people were stuck with a lifetime income that may have resulted in them losing their capital if they died within a few years, would never rise with inflation and offered nothing to a surviving partner. The annuity market was not working well for customers. Most people had no adviser to help them find the right kind of product and even if they did, the drawdown rules were relatively inflexible.  People were told to ‘shop around for the best rate’, but this generally just led them finding a single life, level annuity. This gave them a better rate, but often for the wrong product, rather than helping them make the most of their pension savings.

Criticism of pension freedoms was misplaced: There has been a great deal of criticism of pension freedoms, but they have been brilliant for many of Britain’s pensioners.  Millions of people have been spared from having to lock into record low annuity rates since 2016, which would have left them poorer for the rest of their lives and living on fixed incomes without any inflation protection or spouse cover. And those who pass away relatively young can now pass on their hard-earned pension savings to their loved ones, rather than being swallowed up by insurance pools.

Annuity rates have plummeted following the financial crisis of 2008, when central banks began created massive amounts of new money that was spent on buying bonds: The aim of central bank policy post-2008, was to force down long-term interest rates by buying more and more bonds with newly created money. This meant annuities became more and more expensive as the annuity rate is determined by bond yields.

Recent rate rises and the ending of QE has led annuity rates to rise by 20%, but those who locked in in recent years will not benefit: Pension freedoms have given pensioners the chance to just keep their money invested, benefit from investment returns to help offset inflation rises, while also being in a position to wait longer before locking into an inflexible income stream for the rest of their life and benefit from rising interest rates in future.  Now that QE is coming to an end, the outlook for both interest rates and annuities has changed. Those people who would otherwise have bought an annuity have had the chance to build a better pension fund in recent years.  They are also able to wait longer to annuitise, so that they receive better value from any mortality cross subsidy.  If their health has deteriorated, they are also better placed to receive higher lifetime pensions from an impaired life annuity, that better reflects their likely life expectancy.

More older people can now get better value for their pensions:  Pension savers can benefit from a normalisation of interest rates and also protect themselves against inflation. Many can decide to leave their pension alone, and even add more, or keep working longer, rather than being required to buy an annuity at an arbitrary age such as 60 or 65, which was often the norm for Defined Contribution savers before 2016.

As QE unwinds, traditional pension approaches are no longer safe – time for new thinking: Pension purists insist that a pension fund must provide a lifelong guaranteed income, but that is not necessarily the best approach, especially at a relatively early stage of later life and post-QE. The UK pension landscape is ripe for new thinking, which moves away from one-size-fits-all ‘default funds’ and ‘decumulation’. Most people in auto-enrolment pensions who are close to retirement have been badly let down by their lifestyle or target date ‘default funds’, which wrongly switched them in recent years away from equities and higher potential return assets, into supposedly low-risk bonds.  This approach was aiming to ensure the scheme member was not exposed to huge falls in their pension assets just before retirement. Sadly, the experience since 2022 has been disastrous, with many of these funds losing 20% – 30% of their value as bond yields rose. During 2022, gilts lost 20%, index-linked gilts more than 30%, while the FTSE AllShare and FTSE100 rose 1% (or 4.7% including dividends).  Yes, the FTSE250 smaller companies index fell nearly 20% but overall, supposedly lowest risk assets proved riskier than ever imagined.

But pension funds kept switching people into bonds because they were supposed to be low risk: Without asking members’ retirement intentions, their money was just automatically moved into supposedly ‘safe’ bonds, which plummeted in price as inflation rose and QE ended. These products, relied on by millions of UK workers and investors, have not been redesigned to reflect pension freedoms. They were still targeting annuity purchase, rather than keeping money invested, without checking whether the member was actually intending to retire at the targeted date.  Even as it became clearer that inflation was rising and interest rates would have to increase, most of these funds kept switching to bonds.

New thinking needed as interest rates are rising: The post-QE world is unprecedented.  Nobody knows how the unwinding of central bank bond purchases will play out. Many people are no longer planning to annuitise at any particular age, they may keep working longer and their health may deteriorate. New thinking would enable them to benefit from long-term pension investing that does not assume any particular age at which money will be withdrawn and would ask them each year whether they had particular plans for their pension fund. This would allow new approaches to drawdown, individualised annuitisation at later ages, continuing to invest long past state pension age and benefit from guidance or advice for later life financial planning. Dividing their fund into four parts, with perhaps the tax-free cash for their 60s, then the remaining parts invested for their 70s, 80s and 90s, taking a longer view of investments, rather than encouraging everyone to focus on bonds in retirement.

Individual pensions that recognise each member’s circumstances and needs are required: Especially with the excellent income tax, capital gains and inheritance benefits of pensions, against the background of ending QE, the opportunity for new approaches to lifelong pension provision are there for the taking. It’s time to rethink pensions for the modern world.