It’s been called “the nastiest, hardest problem in finance” by the Nobel Prize-winning economist William Sharpe. It’s the decision coming to tens of millions of us in the decades ahead. It is what on earth to do with the pension pots we have managed to accumulate over the years.
It used not to be much of an issue. People relied entirely on the state pension. Those lucky enough to be in traditional defined benefit (DB) schemes were automatically given a guaranteed, inflation-protected income for life on retirement. The few defined contribution (DC) pots that existed were usually very modest and often cashed in immediately as an early retirement present.
All that started to change 25 years ago as DB schemes were mostly shut down for new employees in the private sector and replaced with DC. The process was given an extra push in 2015 when freedoms were introduced allowing people to more easily forgo buying an annuity when they retired.
Today few new retirees buy an annuity. The majority prefer to stay invested in the stock market, at least for a while, and draw down income from a pot that they hope will continue to benefit from stock market returns. Annuity sales dropped by 75 per cent between 2013 and 2024.
A juggernaut of growing DC balances is coming down the tracks. Getting the decision right is becoming more important for more people with every passing year, according to two timely reports from the Institute for Fiscal Studies. Median DC wealth will rise from about £75,000 for those born in the early 1960s to around £130,000 for those born in the late 1970s.
Longer term, the figures become larger still. Even the lowest earners can expect to accumulate a £150,000 pot by retirement age under auto-enrolment rules. Average earners should be on course for £320,000. That compares to an average house price value today of £270,000.
Paul Waters, head of DC markets at consultants Hymans Robertson, calls them “the DC-only generation” — the rocketing numbers of people who, apart from the state pension, are entirely reliant on unpredictable stock market-linked investments and for whom the decision on whether to annuitise becomes ever more important.
Pot proliferation adds to the difficulty. One in five 18-34 year-olds has already accumulated five different pension pots, according to polling, and the average even for this age group is three. By retirement age, pots in double figures are going to be routine; job-hopping couples could be juggling 20.
Yet pensions providers continue to communicate with consumers as though theirs is their only pot and risk giving pointless guidance as a result. Policymakers, too, underestimate this problem and the confusion and uncertainty it produces. The pensions dashboard (a heroic attempt to give people a summary of all their pensions on a single screen page) may help here — if it ever goes live.
Totting up one’s pension benefits is the easy bit, of course. The hard bit is knowing what to do then. There are other unknowns that can have a life-changing impact just as many people contemplate retirement, not least inheritances and gifts to children to fund their own home purchases. Then there is the tail risk of a share market crash. They do happen. Or the doleful possibility of a long-time stay in a nursing home at £60,000-plus per year.
But the biggest and most unanswerable variable is life expectancy. The IFS says there is going to be a growing problem of people exhausting their pots. People tend to underestimate how long they are likely to live. Paradoxically, too, life expectancy gets harder to judge the longer we survive into old age. Actuaries call it longevity risk, though most of us can think of a happier description for the positive outcome of not dying quite yet.
For policymakers, it’s a growing problem. At the back of all Treasury thinking is the fact that pension tax relief costs the country well north of £50 billion a year. The quid pro quo for that largesse is that no one should be emptying their pots so quickly that they end up being an extra drain on the state.
There’s one other important factor: cognitive decline. It may well be sensible for retirees to defer buying an annuity in order to harness the power of the stock market for a bit longer. Good advice has been to “flex then fix” — stay flexible with drawdown until 75 or 80, then lock in certainty with an annuity.
But that can leave many people with difficult intellectual decisions at the very moment when they are deteriorating mentally. Or when they have been widowed and it was their partner who did all the finances. Financial advice is very expensive. The scope for mis-selling — if not outright fraud — is going to be amplified when people end up making complex financial decisions in their ninth or tenth decades. There is something to be said for the simplicity and certainty of an annuity.
There are no perfect answers and there’s not all that much that policymakers can do. One thing, according to the IFS, is pushing both providers and retirees towards considering at least partial annuitisation. That can be done by carefully designed “default” options in customer choice pathways. Such behavioural nudges can be enormously powerful. The imminent Pension Scheme Bill should pave the way for more of this. As ever, better financial education is going to be important, too.
Encouraging DC pot consolidation will be important. Regulators should be much tougher on life assurers, platforms and others that drag their feet or make endless paperwork demands when customers ask for a transfer-out.
Protecting the public purse is going to matter more. The IFS suggests raising the minimum age at which people can start to access their pots. This is already going up from 55 to 57 in 2028 and needs to go up to 60, it says. Note: the average 60-year-old man lives another 26 years, while women live for another 29 years, and these are just averages. Pots may need to be eked out for a very long time.
It may be a nasty problem, but it is still better than the alternative, of course.
Patrick Hosking is Financial Editor
