When pension freedoms began in April last year, the FTSE 100 index was more than 7,000. Today, it stands at 6,100, a fall of 13 per cent. In February, it was 20 per cent below the April peak.
The pension reforms were widely welcomed, and their first anniversary provides a good opportunity to take an early view on their success.
Along with the benefits of pension freedom come the risks – in particular, the investment risk associated with big falls in the stock market index, inflation risk, and, of course, longevity risk. We should not forget that the primary purpose of a pension scheme is to provide life-long retirement income security for however long the scheme member lives and, when there is no requirement to buy an annuity, there is no guarantee that the member will not run out of money before they die.
These risks are now borne directly by scheme members. Unfortunately, many people do not understand these risks, even with improved financial education. Some risks have to be experienced before they can be genuinely understood. Also, many people will have problems understanding the full range of product choices that are now available. All this makes it difficult for many people to be in a position to make sensible ‘informed’ choices.
How do we deal with this and make pension freedom a success? We should begin by recognising that most people should not be expected to manage retirement risks themselves. This was one of the conclusions raised in the report of the Independent Review of Retirement Income (We Need a National Narrative: Building a Consensus around Retirement Income) published earlier this month.
Instead, pension scheme providers should be designing products and solutions that effectively manage these risks. We also need to remember that one of the important lessons from behavioural economics is that too much choice is a bad thing. This means that people need to be shown only a limited number of well-designed default pathways using decision trees that deal holistically with the scheme member’s total assets and liabilities, health status, family circumstances, tax position, and risk appetite and capacity.
The decision tree will help people decide the best retirement financial strategy for their pension pot. This comprises an investment strategy, a strategy for investing the pension pot during retirement, a withdrawal strategy, a strategy for withdrawing cash from the pension pot to finance expenditures, and a longevity insurance strategy.
A good product for delivering retirement income needs to offer accessibility, a degree of flexibility to withdraw funds on an ad hoc basis, inflation protection – either directly or via investment performance, with minimal involvement by individuals who do not want to manage investment risk – and longevity insurance. No single product meets all these requirements, but a combination of drawdown and a deferred (inflation-linked) annuity does, for example. So a well-designed retirement income programme will have to involve a combination of products.
If any product satisfies these conditions as part of a hybrid solution, it might be considered a safe harbour product. Any adviser recommending such a product, having assessed suitability, cannot subsequently be sued for poor advice. So far ,the FCA has refused to grant safe harbour status to any UK investments.
