04 June 2020
Pension Potty
Prospective Pensioner Poverty
by Frank O’Nomics
Pension pots are disappearing at an unprecedented rate. Over £35bn has been withdrawn from pensions since greater flexibility was announced in 2015, and now those pots are being further undermined by a fall in asset prices and a reduction in contributions. Reasons of fear and necessity are entirely understandable, with worries about the safety of savings and the need to prioritise essential spending. However, such responses bring the danger of major problems in retirement.
First let’s look at the consequences of reduced pension savings. According to a recent survey by Scottish Widows, over 3 million savers have reduced the amount of money that they are putting into their pension as a result of the coronavirus. The most extreme cutbacks have been from those aged 18-24, where 9% have reduced their monthly contributions, and a further 9% have stopped contributing altogether. 20% of this age group has become concerned that they will struggle to pay their rent or mortgage, and regard pension contributions as an acceptable sacrifice. This is entirely understandable for a generation for whom retirement is a very distant prospect. However, for many, cutting their contributions is doubly costly, as it will mean losing a valuable top-up from their employers. As a rule of thumb, to create a pension pot sufficient to fund your retirement you should save a percentage of your salary equivalent to half your age at the time you start saving – so someone starting a pension at the age of 24 should be saving around 12% of their income. The longer one leaves before starting the process, the greater the amount of your earnings you will have to commit. Is 12% at age 24 more feasible to save than 20% at age 40 – particularly if much of the first sum comes from your employer?
What about those with “gold-plated” pensions? For so long, people in defined benefit (DB) pension schemes, receiving a percentage of their final salary according to the number of years worked, have been sitting pretty. Having a guaranteed income in retirement is a source of great comfort. The problem comes when the value of that guarantee is called into question. The total value of the pension funds used to generate this income has been hit very hard by the impact of the coronavirus crisis on asset prices. Actuarial consultants LCP estimate that a additional “black hole” of £100bn has been created. The only way this hole can be filled is for the corporate sponsors to inject more capital. Given the current state of corporate finances this will be very difficult, and the Pension Regulator has recognised this by giving extra time to plug the gaps, so as not to undermine a company’s future. However, indefinite deferment is not feasible, and at some stage many more companies will have no choice but to seek the support of the Pension Protection Fund, which could mean a loss of income to pensioners of up to 20%. The problem is not quite as severe as it may sound given that, of the 7.4 million people still in DB schemes, 6.3 million are public sector employees (whom one would hope have much better protection).
The bigger problem is likely to come as a result of people cashing in their defined benefit pensions. Since pension freedoms came in 2015 savers have been able to transfer out of a defined benefit scheme into a defined contribution (DC) scheme when they reach the age of 55. The lump sum offered to buy someone out of a DB scheme can be as much as 35 times the annual income that the scheme generates. By putting this into a DC scheme instead, the pensioner can vary his level of income according to their needs and wants. It may seem attractive to have greater control of your pension; particularly as many will want to spend their savings while they are young enough to enjoy doing so. It may also be very tempting if you have concerns over your previous employer’s ability to fill any gap in the DB scheme. The problem comes when the likes of the current crisis hit the value of the DC fund. All of a sudden the guarantees of the DB scheme look much more attractive. Many who had a traded-in a perfectly acceptable guaranteed income for life, could find themselves running out of money.
For most, outside of the public sector, DC schemes are now the norm, given that most DB schemes have been closed to new entrants for some time on grounds of cost. Those living from the capital in their defined contribution pension schemes have been taking money out at an unprecedented rate. On retirement, some people use their pension pots to buy an annuity to secure a rate of income in retirement, but the low level of annuity rates (resulting from the fall in long-term interest rates) has encouraged many to use an income drawdown approach instead. According to the Association of British Insurers, 40% of those with DC schemes have been withdrawing from their pension pots at a rate of 8%, compared to the 3-4% rate of withdrawal recommended to avoid running out of money in retirement. The combination of falling asset values and higher drawdowns could again leave many running out of money very quickly. It is easier said than done, but the safe approach would be to withdraw only the dividend income and interest payments received into your pension pot to protect the capital value for as long as possible. The issue with this is that the sum generated is likely to be less than 3%.
The problem with pension freedom is that it runs the risk of giving people the freedom to fall into penury in old age. There are some protections in place. Anyone with a pension pot of over £30,000 is required to seek advice, but seeking and taking are very different responses. When it comes to pensions, the maxim -If you don’t need it don’t take it – is worth following. However, it is very easy for those who are comfortable to advocate such an approach. The current crisis will have many long-term consequences and, sadly, greater poverty in retirement could well be one of them.
