By Dale Critchley, Workplace Policy Manager, Aviva
Pension drawdown was available but was limited by a maximum drawdown rate, it was often sold on an advised basis, and only those with sufficient guaranteed income could access uncapped drawdown.
Pension freedoms expanded the options available to DC savers, offering huge opportunities to shape a retirement income to meet individual income needs. But it also created what William Sharpe, Nobel Prize winner and professor of finance, described as “the nastiest, hardest problem in finance” – the risk of running out of money during retirement.
We know that when faced with a choice, human behaviour kicks in. The present bias or hyperbolic discounting is where people choose smaller and more immediate rewards – such as a cash lump sum, rather than larger later rewards – such as an income for years to come. Unlike an annuity, drawdown income might be deferred for a decade or more, making it difficult to relate to a future-self who is older and no longer working.
Herd mentality might also lead pension savers to believe the most popular option must also be the right one for them. While an actuary looking at a solution for a large pension population can approach the problem based on long term averages, the average is not always useful to an individual. For example, savers might make a retirement income choice based on the average life expectancy. However, half the population lives longer than the average person. Among women aged 65-years-old the average life expectancy is 87 but one in four will live to 94 and one in ten to 98.
When it comes to investment returns both the level and volatility of returns are difficult to predict at an individual level. The average return over the past 20 years might be very different to an individual’s experience.
It is for these reasons that decumulation options are currently evolving at pace and defaults are being discussed.
There are proponents of collective defined contribution as a default decumulation option. Pooling of investment and longevity risk provides opportunities to deliver higher pension returns on average. Although the potential need to forgo a death benefit might mean it is not appropriate for everyone.
Pension freedoms allow people to access their tax-free cash lump sum and defer their pension income. This can be hugely valuable because triggering taxable pension income also triggers the Money Purchase Annual Allowance. It effectively rules out any immediate pension as a default.
Drawdown is the de facto default for savers who have it as an option within their scheme. Crystallised benefit not paid as a tax-free cash lump sum is designated to provide flexible drawdown. It remains invested, to be withdrawn when the saver chooses. This seems like a worthy candidate for a default but leaves the question of how to align investments with the needs of savers who might plan to take an income at any point and how to deliver a sustainable level of income.
Hybrid options have the advantage of nudging savers toward a dependable income for life without committing them to it. Just as some savers would not want to be defaulted into an annuity at 65-years-old, some might not want the same to happen at 80.
While legislation might provide a regulatory safe zone to enable defaults to operate effectively, engagement with pension savers seems to be the way forward. Developments like targeted support allied with innovative online tools and an appropriate choice framework have the potential to empower individuals to make the right decision for them. This should be the goal.
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