Pensions - Articles - A speech by Andrew Bailey from the FCA on Pensions

 At Gleneagles, 2 years ago I spoke about the macro-economic perspective, and particularly the role of the lifetime saving model and how it can illustrate the challenges of today. I’m not going to give that speech again, honestly, but I do want to reprise one or two points, just to take the argument on.

 The model says that people make choices about how they spend and save at each point in their lives limited only by the resources available over their whole lives and thus independent of income at each point in their lives. Decisions on spending and saving at each point in people’s lives are thus linked to building up and running down assets to provide for retirement, among other things.

 Ok, but what that tells us is that at each point in our lifetime we take decisions in the context of a series of judgements about the whole of our lifetime over which there is a very large degree of uncertainty. Let me pick out 4: our life expectancy; our lifetime earnings; our lifetime spending and saving; and the expected real interest rates over the course of a lifetime, which determine the cost of saving and borrowing and are factored into discount rates for asset valuations.

 It goes without saying that all of these are highly uncertain, and subject to risks either way. Let’s look at a few changes: average life expectancy has been on a steadily rising course, though in the last couple of years the rate of increase has reduced. For the last 10 years – since the financial crisis – long-term real interest rates have been at a low, and at times negative level, a very unusual occurrence at a time when by longer historical standards inflation has been quite stable. And there are good reasons to believe that the equilibrium real interest rate – ‘R-star’ as economists call it – has fallen. On the borrowing side, much more of the cost of student education is being transferred to individuals in the form of debt obligations to be paid off later. On the saving and investment side, for many the real cost of housing has increased. Now, let’s throw in the ingredient that we are most interested in here. There has been a progressive shift in the responsibility for both retirement saving and pension drawing from employers and the state to individuals.

 Amid these changes, the lifetime model remains in my view the best organising framework to consider the issues we face. The basic pattern that individuals typically move from being net debtors to net asset owners across their working lives and then draw down on those assets in retirement has not changed. But, the contours of the pattern have changed and I would argue that there is now more uncertainty about how those contours will take shape as generations and within them individuals age. We are seeing some large inter-generational shifts in those contours, and they raise very important issues in the area of pensions and long-term saving and indebtedness. Moreover, the increase in uncertainty poses very clear challenges not just for the provision of pensions, but also for the provision of advice to individuals on the decisions that go with pensions. There is no doubt a tension, even a contradiction, between the degree of uncertainty and the apparent certainty embedded in the design of financial instruments.

 One of the important things that we at the FCA have done in the last two years is to publish our first Financial Lives study, we think the most comprehensive study to date of the financial lives of a set of UK residents. And, with deference to the lifetime model, it is no coincidence that the first version we published split the population up by age (we have if you are interested since published the same study on a regional basis). What did we find of relevance? Quite a lot perhaps unsurprisingly, and the evidence we found is consistent with what we see and hear elsewhere. Debt levels among the younger age cohorts - broadly up to the mid-30's - have increased (since we don’t have a time series of our survey, we have to rely on other evidence to support what we found in terms of change over time). A good part of this increase represents student loans, and of course it is important to note that the adjustment to larger student loans is still working its way through the age cohorts. There is a debate about whether student loans are strictly debt or not, and the answer is that it depends for what purpose they are being assessed, but for the lifetime model they should be counted in because on average people will repay them out of income.

 A second observation is that along with the increase in the real cost of housing for many goes later entry into the owner-occupier housing market, and thus mortgages extending later into life. Another part of this story is that we are seeing the average term of mortgage lending increase in response to the higher real cost of housing. Again, these are changes that are still working their way through age cohorts, and so we can expect to see further changes in the contours of the lifetime model. But it is reasonable I think to conclude that debt servicing costs will on average be larger for longer into people’s lifetimes. And, of course, this means that they are competing with saving for retirement, and at times when in the past people have tended to increase such saving as debt servicing costs fall.

 What do we see in terms of evidence on retirement saving? Our Financial Lives Survey indicated that just over 15 million adults in the UK who are not retired claim they are not currently paying into a pension. We also found that a sizeable proportion of defined contribution (DC) pension savers have relatively little in their pension pot. Around 22% have less than £5,000 and a further 14% between £5,000 and £20,000. Moreover, we found that 24% of employees did not have a pension. In recent years, governments have taken important steps to tackle this issue, notably auto-enrolment and the creation of the National Employment Savings Trust (NEST) and we welcome these steps. Auto-enrolment has already made a difference to the number of consumers saving into a pension, and there is more to come. And, we welcome the Department for Work and Pensions’ (DWP’s) review of auto-enrolment. Another of the findings of Financial Lives was that 51% of self-employed people, who are not currently covered by auto-enrolment, do not have a pension at all. It is good that this is under consideration as part of the DWP review.

 Before moving on to what the FCA is doing, I want to tackle one big question which is linked to the whole issue of the changing contours of the lifetime model, namely are the pension freedoms still the right approach? It would I suppose be possible to duck the question by arguing that it is too late to change course, but I think it still merits an answer based on the latest evidence. The answer for me is Yes, the freedoms remain the right course to follow, but supplemented by an expansion in the scale and scope of auto-enrolment, so it isn’t a total free-for-all. My reason for taking this view is that while the contours of the lifetime model will always change, it is unlikely that we will turn the clock back in the foreseeable future, and greater freedom of choice over decumulation – when and by how much and in what form pensions are put into payment – makes a great deal of sense in terms of the shifts in and uncertainty around the lifetime model.

 But – and there is always a ‘but’ I’m afraid – we need to be very aware and alert to the consequence I mentioned earlier, that we have transferred the responsibility for a very complex area of decision-making to individuals, and we need to do all we can to help people make those decisions. And that is where the FCA, among others, comes in.

 As a reminder, the FCA regulates firms that operate contract-based pension schemes: these are schemes based on individual contracts between the member and the provider. They include personal pension schemes such as self-invested personal pensions (SIPPs). The Pensions Regulator (TPR) covers trust-based schemes where a scheme asset is held in a trust for the benefit of members. In term of numbers, there are around £2.4 trillion of pension assets in the UK, of which around £955 billion is in the FCA world and £1.45 trillion in the TPR world, with the balance gradually shifting towards FCA regulated schemes.

 The FCA’s other main role in this area is to be the conduct and prudential regulator for financial advisers, brokers and other firms and individuals advising on and selling, retirement income products, to be the conduct regulator for insurers, and to monitor and set the standards under which Pension Wise operates.

 The FCA has 3 operational objectives: to secure an appropriate degree of protection for consumers; to protect and enhance the integrity of the UK financial system; and to promote effective competition in the interests of consumers. They rank equally: we don’t have a hierarchy, and it would not be appropriate for us to have one. It does mean that we are a full-scale competition regulator, and in this context we want to see a more competitive retirement income market with products that meet the needs of consumers.

 The pension reforms have provided the opportunity for the FCA to take a sector wide look at the retirement income market that we regulate. We started this work with the Retirement Income Market Study, the final report of which was published in March 2015. This found that a lack of shopping around meant consumers were missing out on the most appropriate annuities for them, so-called “’wake-up packs” ‘ were too long and hard to understand, and consumers were highly sensitive in terms of their choices to the way retirement income options are presented.

 The pension freedoms have been the backdrop to the next stage of our market-wide work, the Retirement Outcomes Review launched in July 2016. The purpose of the review has been to assess the role of competition in a market where products and options for accessing retirement income have become more fragmented. We have looked at how consumers and firms have been responding to the pension freedoms; focusing particularly on those consumers who do not take regulated advice.

 Obviously, the review has taken place against market and consumer behaviour that has been responding to the new freedoms, but we are seeing some clear patterns emerge.

 Since the introduction of the freedoms in April 2015, just under 2 million pension pots have been accessed for the first time. Around half of these are full withdrawals of the cash in the pot, though it is important to bear in mind that the average size of these withdrawn pots is small at around £15,000. Moreover, full withdrawal of cash is more likely to be undertaken by people under the age of 65.

 In terms of pensions coming into payment and the type of payment product, there is strong growth in drawdown products and a reduction in annuity sales. Of course, in terms of the stock of pensions in payment, annuities still dominate, with the latest figures showing just over 7 million annuity contracts in payment versus around 860,000 drawdown plans. That will, however, change over time. Interestingly, the latest figures we have for the 6 months to the end of March this year show that around 60% of drawdown sales involve no income taken. The latest figures suggest that around 30% of drawdowns were non-advised, and for both drawdowns and annuities the proportion of non-advised sales has increased. The evidence also suggests that around one in three individuals was unaware of where their pension assets were invested, but the proportion using pensions guidance is rising, albeit that figure remains just over 10%, suggesting a sizeable proportion taking neither advice nor guidance.

 The important question is what do we make of all this, accepting that it remains early days on the freedoms? The switch from annuities to drawdowns is unsurprising, and was a main plank of the change. Cashing out small pots is in one sense unsurprising. The proportion of drawdowns not involving income taken strikes me as a good example of the sort of flexibility people want to have under the freedoms.

 Finally, the pattern on advice and guidance underlines three important challenges where I want to see progress: first, in the light of the finalisation of the Financial Advice Market Review (FAMR), that it does provide greater confidence particularly in the advice: guidance boundary; second, that innovation and technology does begin to assist in the challenge of providing lower cost advice for those with smaller and/or simpler needs; and third, that the welcome introduction of the Single Financial Guidance Body does lead to greater awareness and use of pension guidance, and particularly Pension Wise.

 Meanwhile, we have recently published the final findings of the Retirement Outcomes Review, and intend to have final rules on all the issues raised in place by next July, to be followed by an implementation period. Overall, we have concluded that many consumers have welcomed the pension freedoms and the ability to access their savings in ways that they previously could not. But we have also seen that many consumers, particularly when focused on taking their tax-free cash, take the path of least resistance and enter drawdown with their existing provider. We expect levels of engagement to increase over time as pot sizes grow, and we found some support for that conclusion from the experience elsewhere in the world. However, as pots become larger, those who do not engage effectively could lose out on income in retirement, through poor investment choices or paying higher fees and charges.

 One dog that has so far not barked is that while commentators have flagged the risk of consumers drawing down their pension assets at unsustainable rates, we have not so far seen much evidence of this taking place. This is unsurprising I think, not least because on the basis of the numbers of pot sizes drawn down, they would not allow much of a Lamborghini to be bought. And, to be clear, while I always try to ensure that the FCA’s observations are well researched, this is on the basis of absolutely zero experience on my part at least of trying to buy a Lamborghini. However, as pot sizes increase and DC pension savings become a more central part of many consumers pension wealth, the broader issue of unsustainable rates of drawdown will be important to watch out for.

 We were concerned to see that some providers were ‘defaulting’ consumers into cash or cash-like assets. Just over 30% of non-advised drawdown consumers are wholly holding cash. This may suit consumers planning to drawdown their entire pot over a short period, but it is unlikely to suit those drawing down over a longer period. We estimate that over half of these consumers are likely to be losing out on income in retirement by holding cash. Someone who wants to drawdown their pot over a 20-year period could increase their expected annual income by over 30% by investing in a mix of assets rather than just cash.

 We are also concerned about the high proportion of consumers fully withdrawing their pension pots to move savings elsewhere. In many cases, keeping money in a pension would have resulted in better returns on average, and in paying less tax (and this is a general observation, not tax advice from the FCA, to be clear). Some consumers might also lose out on employer contributions and other benefits as a result. We found this behaviour was partly driven by a lack of trust in pensions, stemming from a range of factors including past pension scandals and frequent changes to pension rules and tax treatment.

 Our evidence also suggests that if firms offer consumers a more structured set of options – making the decision simpler to navigate – it can improve the investment outcomes for consumers, better aligning with their objectives in retirement.

 We also found weak competitive pressures and low levels of switching in the non-advised drawdown market, and looked at whether this might drive higher prices and less innovation. Comparing the behaviour of advised and non-advised consumers presents a starkly different picture. 94% of consumers who accessed their pots without taking advice accepted the drawdown option offered by their pension provider, compared to 35% for advised consumers. Given this lack of competitive pressure, we are concerned that consumers might pay too much in charges. Our evidence indicated that charges for non-advised consumers can vary substantially between products and are on average higher than in accumulation. We estimated that by switching from a higher cost provider to a lower cost-one, consumers could increase their annual income by up to 13%.

 Drawdown charges can be complex, opaque and hard to compare. Products can have as many as 44 charges linked to them. This makes it difficult for consumers to compare and shop around for the best products for their needs, and this limits competitive pressures on providers. Similarly, our review of non-advised drawdown pensions sales, published in March, found that some consumers struggle to fully engage with the information providers give them. This can affect the quality of decisions.

 So far, we have not seen significant product innovation for mass-market consumers. The market is of course still in the process of adjusting to pension freedoms, and the incentives to innovate will increase as pot sizes grow. For that reason, we intend to allow more time for the market to develop before we consider whether further action is needed on product innovation, but it will be a very clear focus for us over time.

 Our focus therefore in framing measures to take to respond to these findings has been to seek to shape an emerging market, not shake-up an entrenched one. Our objectives include improving the effectiveness of consumer communication before they access their pension savings, and that they have appropriate access to support and guidance. To improve engagement, we are therefore proposing that consumers should receive wake-up packs earlier and then more consistently, so from the age of 50 and subsequently every 5 years until they fully crystallise their pension pot. There should be a single page summary in the pack, and clear risk warnings. This seems to me to be consistent with the changing contours of the lifetime model.

 We also want to ensure that consumers receive the support they need, from regulated advisers, providers and Pension Wise.

 We have also floated a number of ideas which are not yet ready for consultation, in the sense that fuller evaluation is needed, including on how they could apply to SIPPS. One is to introduce a more structured approach to engaging in decisions by creating a small number of ‘pathways’ (we have suggested 3 might be an appropriate number of such pathways) which would provide sensible options for those with fairly straightforward needs. There is a careful balance to be struck here: on the one hand, we want to see consistent help for those at risk of being lost in complexity; but we recognise the danger of it becoming 3-sizes-fit-all, and particularly in view of the points I made earlier about the contours of the lifetime model.

 Another floated idea is preventing firms from defaulting drawdown consumers into cash, to make sure that investing in cash is an active decision in drawdown rather than something that happens due to indecision. Alongside that, there is a good case for more transparency on drawdown features, including charges, both for those considering it and those already in it. For annuity purchases, we are proposing to extend our information prompt to cover enhanced annuities, which should result in more consumers getting a better annuity rate.

 Finally, on the review, we have considered whether there should be charge capping, a point raised by the Work and Pensions Committee. At this stage we are not convinced, though the option is not closed off, and would never be so. But in a market where we want to see evolution and innovation it is hard to know the right price, and there could be negative effects on innovation and competition. As a point of reference, the fee level of 0.75% on default arrangements in accumulation would at the least prompt the question of why fees for some other products are higher for some consumers. Our intention is to review charges in the light of how they evolve, as part of the review we will undertake around a year after implementation of rule changes arising from the Retirement Outcomes Review. If we find problems with charges, then capping will be on the table as a response.

 To conclude on the review and the context in which it has been undertaken, I continue to believe that the pension freedoms are an appropriate response to the changes in the lifetime model, and the uncertainties around what can happen in the future. But, we must recognise that these changes are another part of a longer shift towards making individuals responsible for retirement saving and the complex decisions that go with it. So, we have to do all that we can do enable individuals to take these decisions, and we have to be prepared to intervene early, while the market is still developing. The benefits of doing this will come if we avoid unwanted practices becoming entrenched and over time consumers have confidence in their pensions.

 I want to finish by briefly mentioning another initiative that we are pursuing. We and TPR have committed to publishing a joint Pensions Strategy. The intention is to outline our priorities for the next 5 to 10 years and our appraisal of the risks facing consumers. It will set out our respective remits and how we work together. Over the course of this year we have held a number of joint events around the country to engage with as many stakeholders as possible. You might be thinking now, 'why has it taken until now to come up with the idea of a joint strategy?'. I don’t know the answer to that one, but I can say that it seems to make sense now more than ever in view of the fluid picture as pensions and long-term savings adapt to the challenges at the extent I set out at the start in discussing the lifetime model.