Lessons from Down Under
In less than 3 months, UK retirees who in the past may well have brought a lifetime annuity will be given the right to take cash lump sums- as much as they want, when they want- direct from their pensions. Will this reform, dubbed pension freedom, actually help retirees to enjoy higher living standards?
The evidence from Australia, where retirees have had the same right for years, is hardly compelling. Just before Christmas, a high level report exploring threats to the country’s financial system concluded superannuation pension assets are not being efficiently converted into retirement incomes because of a lack of risk pooling and an over- reliance on drawdown styles pensions.
It said, “This contributes to a lower standard of living for Australians in retirement and, for some, during working life, meaning people have to save more than they did previously to reach the same level of retirement income.”
In many ways the Australian system is ahead of its time. Quick to pick up on the challenge of longer lives (the country has the world’s fourth longest average life expectancy) it introduced compulsory minimum employer pension contributions in 1992, more than 2 decades ahead of the UK’s adoption of auto- enrolment. That foresight has helped many Australians build up good levels of pension provision. However, one of its big weaknesses noted in the Financial System Inquiry led by banker David Murray is retirees are not using those savings well. They find it challenging to navigate the transition to the retirement phase and, although prompted to take professional advice, many choose not to. The result is 94% of pension assets are in account- based pensions, similar to income drawdown, where retirees have no guarantees about their income their pension might generate.
The report notes the evidence that Australians are concerned about exhausting assets in retirement, with research suggesting more than half are “worried” or “extremely worried” about outliving their savings. When asked to identify the single most important factor in a retirement income product, twice as many people chose “income that lasts a lifetime” as any other option. Faced with the real risk of outliving their assets, people choose to live more frugally in retirement and draw down assets at the minimum allowable rates.
“This is what the majority of retirees with account- based pensions do, which reduces their standard of living,” states the report. In the UK, there are concerns the new freedoms will encourage people to take pension assets too quickly. While that is certainly a problem in Australia, with around a quarter of people with superannuation funds at age 55 depleting those funds by age 70, the far bigger problem is failure to draw on their pensions. Worried about the future, they save too much while working and hoard pension money when in retirement. That fear of consumers to consume not only leads to poorer lives but also impacts on the wider Australian economy.
The report suggests Australians’ standards of living would be improved through greater risk pooling. It recommends the development of guaranteed lifetime income solutions that allow retirees to manage longevity and investment risk more effectively, giving them confidence to spend their pension money without worrying about it running out while also retaining some flexibility.
To encourage take-up, particularly among the disengaged or less financially sophisticated, these would have government- approved features and be offered by pension schemes as a default option. As well as allowing a smooth transition into retirement, it would still give people the freedom to opt out and take benefits in a different way.
“Greater use of products that pool longevity risk could significantly increase retirement incomes,” states the report, which estimates the gains could be incomes 15-30% higher than the current typical strategy of drawing down the minimum income (currently 5% of fund value each year for Australians aged 65 to 74, rising with age).
In many ways, Australia has an enviable pension model. For example, the typical balance in a mature superannuation fund is nearly £215,000, far bigger than the average private pension pot in the UK. Yet pension freedom appears to be costing them dear and the solution is to encourage take- up of products that help them deal with the ups and downs of investment markets and the possibility their funds may have to last many decades.
You could almost say that, in the absence of a competitive annuity market, the Australians have decided they must invent one. As we gear up for our own experiment with pension freedom, to begin in April, there is clearly a lesson to learn from the Australian experience. One good definition of freedom is not having to worry about whether the income we rely on will still be flowing tomorrow, next year and for the rest of our lives.