Future of Retirement
I’m sure many readers will be thankful that the UK Government’s recent Spring Statement avoided further tweaking of pensions rules. Of course, the same could not be said of the 2014 Budget, which changed the retirement income market irreversibly.
In April, UK Pensions Freedoms celebrated their 10th birthday – so what better time to look back at the changes, discuss the choices being made by retirees today, and to consider what the future of retirement income will be?
Let’s start with a quick reminder: from 2015 the default expectation – of using a defined contribution pot to purchase an annuity – was removed. New pensioners ventured into an entirely different landscape, with much greater freedom to drawdown from their plans flexibly (or, perhaps, to cash it all in and satisfy their lust for a Lamborghini, and yes: I am sorry, Steve Webb, for bringing up that quote again).
Drawdown drawbacks?
There is little doubt these pensions freedoms have been popular, but the perennial question is: are they going to run out of money? Sadly, there’s a lack of conclusive answers.
One of the more helpful data sources is the Financial Conduct Authority’s Retirement Income Market data which covers the choices being made by drawdown customers:
Now is probably a good time to mention Bengen’s Rule. It suggests that the maximum safe withdrawal rate (SWR) from a diversely invested portfolio is somewhere around 4%-ish, at least based on historical data from across the pond.
Note to readers: the author of this article accepts no liability if you find an ill-timed market crash, annual management charges, income tax, ill-advised investment allocation, or any other reason means that 4% rule doesn’t work out well for your older self. Clearly, all the investment and longevity risk has been passed to the retiree.
The FCA data suggests those that have squirrelled away the most into their pension seem to be the most cautious with their withdrawals – and in fact some may be overly prudent with a <2% withdrawal rate. Perhaps they are hoping to pass on some of those pension savings to the younger generation, but with pensions forming part of the estate for inheritance tax purposes from 2027, that strategy has become materially less attractive – it will be interesting to see if that legislative change impacts future data.
However, even the most optimistic investor should surely be concerned about the sustainability of the high 8%+ rate of withdrawal, which are the most prevalent for pots valued at less than a quarter-million.
The data here has obvious limitations. One issue with the analysis is that those with the smaller DC pots might be more likely to have other adequate DB or DC pension resources elsewhere. However, a sceptic might say that individuals in every pension size bracket seem to be simply withdrawing roughly whatever is needed to fund modern life in the UK, regardless of their pot size.
The extent to which the Government will find demands on its future precious limited resources (from those who have drawn down too quickly, or lived longer than they had expected) remains to be seen.
The longevity point is important too: a concerning factor is that Brits are notoriously poor at predicting their own life expectancy. For example, one AJ Bell survey of drawdown customers retiring aged 55-59 (I’d presume a group that contains at least a few affluent individuals) expect a 21 year remaining duration of retirement on average. The CMI tells us that would be a serious underestimate for most; in fact, even their cohort life expectancy from age 65 is higher than that!
Annuities revitalised
Contrary to popular belief, the annuity market is not dead yet, far from it. The higher interest rate environment in the FCA’s 2023/24 data gathering period saw annuity prices fall and hence annuity incomes rise – making them a somewhat more attractive proposition, albeit still the minority option (by both number and by fund size).
At the time of writing, a single-life, unenhanced, inflation-linked annuity from age 65 should now pay back over 5% of the single premium each year. That compares favourably to Bengen’s SWR and so we might expect the popularity of annuities to continue to improve, perhaps even more so given the IHT changes.
On paper, an inflation-linked annuity will seem to many like the best of both worlds: more certain inflation protection (only indirectly available to drawdown customers by investment in assets expected to earn real returns) combined with the longevity protection too.
However, the data suggest many retirees still have lingering doubt: “what if I didn’t buy that annuity…?” – what if they wait and interest rates rose further, what if they have a health condition they feel is not fully priced-in, or what if they want to leave behind an inheritance after all? Are annuities too inflexible?
Residential mortgage customers are already familiar with the prospect of refinancing their debt via a series of 2-to-10 year “fixed-rates” which provide some limited short-term certainty, without the inflexibility of locking-in to a rate for the full mortgage term.
Well, this approach has reached the annuity market too, with several life insurers already offering (or having recently announced) fixed-term annuity products.
For the customer, buying a series of fixed-term annuities allows for occasional step-changes in the level of income as spending needs adjust throughout retirement. For insurers, fixed term annuities avoid two key issues which have deterred them fully backing traditional whole-life annuities: there’s none of the capital-intensive longevity risk, and no need to source potentially elusive high-yielding very long-duration assets.
There’s a lot more that could be said about the annuity market e.g. the increasing sophistication of enhanced annuity underwriting, or annuities linked to investment performance. It will be interesting to see the fruits of the product development we know is taking place over the coming months and years.
Collective Defined Contribution (CDC)
Discussions about whether some of the investment and/or longevity risk should be passed back to the provider are now also seen in the world of occupational pension schemes. I want to highlight the October 2024 launch of Royal Mail’s Collective DC (CDC) workplace pension scheme, the first of its kind in the UK.
CDC defines the level of contributions to be paid (6% employee and 13.6% employer in this case). However, CDC members do not build up their own pension pots and there is instead one pot in which all contributions are invested. The scheme then offers pensions in a “defined-benefit format” i.e. expressed as a lifetime income and perhaps a lump sum at-retirement. However, unlike a DB pension, the benefits can be adjusted upwards and downwards reflecting their affordability relative to the accumulated contributions.
For members, longevity risk is mitigated, with longer-lived individuals subsidised by members who die at earlier ages. For employers, the over-arching key DB pension risk (i.e. that the scheme requires further, unexpected contributions to remedy an emerging deficit) has largely disappeared.
However, there are some downsides to the CDC approach, and not all are obvious – for example, there are anti-selection risks posed by the right of members to transfer out their share of their pot i.e. less-healthy members might be more likely to do so, leave the population, and thus reduce the crucial cross-subsidies. Equivalent structures in other countries have had to introduce compulsory participation to ensure that the scheme remains fair to continuing members.
At the time of writing, it does not appear that there is another scheme quite ready to adopt the CDC structure; however, expect movement and refinement of this product in the coming years.
Conclusion
I encourage and invite all readers to draw their own conclusions on what the future of retirement incomes should be. I suspect the high-level product design to mainly depend on macroeconomic factors but also whether there is the political and industry will to properly understand and tackle the potential risks that our auto-enrolment led drawdown-dominant pensions landscape poses.
I hope that personal and occupational pension providers accept that a choice between two “extremes” i.e. lifetime annuities vs. unlimited drawdown is unpalatable for some, and that this 10th anniversary of pensions freedoms spurs further steps towards creative product innovation.
Gaetano Donato
May 2025
