It’s been ten years since pension freedoms legislation came into force, giving pensioners more choice about their pension pots. In the early days some voiced concerns that they would spend their entire retirement savings on Lamborghinis or fancy holidays, leaving them destitute in old age.
None of this happened, of course. A frugal saver wouldn’t just turn into an irresponsible spender. Instead, it often led to the opposite — decision paralysis. Because too many options can make it difficult to know what to do.
It wasn’t much of an issue when gold-plated defined benefit pensions, also known as final salary schemes, which give employees a generous and guaranteed pension income in retirement, used to be the norm. In the mid-1990s most employees had a defined-benefit pension, but the schemes are now almost extinct in the private sector.
Today, defined contribution (DC) schemes (where what you get in retirement is based on what you pay in plus investment growth) make up the majority of workplace pensions. Between 2021 and 2023, 59 per cent of 55 to 64-year-olds had some DC pension wealth, up from about 44 per cent 15 years earlier, according to the Institute for Fiscal Studies (IFS), an economic researcher.
While pensioners’ decisions about money held in a DC scheme are relatively low-stakes at present (only 19 per cent of those aged 55-64 have more than £50,000 in this kind of pension), it soon won’t be: this type of pension wealth will only grow.
The problem today is that we are all expected to be our own financial planners. Before the pension freedoms you had to buy an annuity with your pot — an insurance product that gives you a set income for life. But now, if you’re in one of these schemes, you have to make active decisions about how to draw your pension. And there is so much to consider.
There is a longevity risk you have to watch out for. Anyone with a DC pension will have to second-guess their life expectancy to figure out how long they need their pot to last and the best way to draw on it.
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There is also a cognitive risk. People are not only living for longer, but they are also living in ill health for longer — if you survive for long enough, there is an increased possibility your mental health will become impaired. One in three people born in the UK today will get dementia, according to the Alzheimer’s Society. While you might be willing and able to make choices with your savings when you first retire, it could become impossible if your mental health deteriorates. It is hard to know exactly when managing your pension is no longer feasible.
And then there’s the investment risk. Remaining in active drawdown — where your pot is still invested in the markets, which is one of today’s options — means that you will have more complex financial decisions to take at older ages compared with if you draw a regular income from an annuity.
There’s a tax risk too. Following bumper rises to the state pension, anyone who gets the full new state pension will pretty much see their personal tax-free allowance wiped out. How much to draw from your private pension on top of that has become a game of tax. Should you stagger chunks of your 25 per cent tax-free lump sum over time to supplement your income to avoid tax? Or even defer your state pension for a couple of years?
Making pension decisions used to be something you did before retirement, not in retirement. Now you’ll need to manage your pension long after you’ve stopped working.
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Worryingly, though, about four in ten 50 to 64-year-olds with DC wealth say they do not know how they will access their savings, according to the IFS. Most of the pots that were accessed for the first time belonged to people who had not sought any guidance.
Not everyone wants to be their own financial planner — or should be.
