Finely crafted investments



Landmark Pension Reform

Posted by Paul Jourdan on 20/Mar/2014

Ending the monopoly of annuity providers over pensions is George Osborne's defining moment. We think it is inspired, albeit it might have been driven by practical politics and the desire to win back potential UKIP voters. Investors in pensions have had to put up with a lot over the years: extraordinary complexity; constantly changing rules; massive hidden charges (now gone thankfully); poor advice (also now much improved). But there were ways of dealing with all of this. However, after years of putting money aside into savings designed to provide for retirement, there was no getting around the obligation to make, what for many would be a very poor investment decision: buying an annuity. And this was also exactly the moment when all of the complexity, hidden charges, and poor advice were most likely to come into play. It was also an irreversible decision.

The idea of removing the obligation to buy an annuity had been discussed for years, mostly notably by Frank Field MP. His conclusion broadly was that the compulsory annuity mechanism, even though it was in many ways patronising and unfair, provided protection to poorer and less sophisticated savers which could only be made possible if the wealthier and more sophisticated were forced to take part, and that this was a price worth paying.

However, there are a number of virtually unquantifiable factors to consider in reckoning whether this conclusion holds good. First, there is the tendency towards uncompetitive pricing from the annuity industry based on the fact that there are forced buyers. Second, there is the fact that very few buyers realised that they could shop around for the best annuity rates, although that changed considerably over the last decade. Whilst those who bought annuities in an era of high interest rates would have looked good as rates collapsed, for most, annuities were a massively sub-optimal investment, resulting in no inheritance to be passed on to descendants. Third, the fact that an excess of savings were going into insurance based products is likely to have meant that huge amounts of capital were being tied up in relatively unproductive areas, resulting in an inefficient allocation of capital across the economy. In other words, savers who could afford to be more adventurous were not allowed to be. Fourth, it was revealed in the credit crunch that the idea that annuities would protect pensioners in the event of a financial catastrophe is deeply flawed. The annuity providers themselves would not have withstood a financial meltdown in 2008 had it not been averted, and the government would have been left to pick up the pieces in the same way that it would if it was individuals whose savings had been wiped out.

Now that the announcement has been made, it immediately seems obvious that it is the right thing to do. It is no accident that the decision has been taken in an era of super-low interest rates, in which buyers of annuities are hugely exposed to rising inflation, and who are likely to look back with great regret as interest rates normalise. Frank Field himself might now agree with the outcome. In the US, where annuities are not compulsory, around 10% of pensioners still opt for the security of an annuity, so this option won't fall away, and we can expect to see much more innovation in the provision of annuities from here on. In the same way that Gordon Brown's best moment was granting the Bank of England independence over monetary policy, George Osborne's is likely to be the pension reform of 2014, unless he has some other rabbits to pull out of the hat yet.