On 28 March 2018, the House of Commons Work and Pensions Committee published a new report on pension freedoms. They identified a ‘philosophical difference’ in the current approach to accumulation and decumulation policies.
The success of auto-enrolment has shown that the market welcomes a default option for those who start to save for their retirement; furthermore, the new policy directly addressed consumer inertia in pension saving.
At the moment, no such default is available for those nearing their retirement age. Instead, pension savers are assumed to make an informed choice between a wide variety of options, including tax-free cash withdrawal, annuity purchase or a move to one of many drawdown solutions. As the report rightly points out, while the accumulation journey could be passive, the decumulation one is definitely active.
Yet it is an active choice that some may not be prepared for. A recent YouGov survey revealed that one third of consumers in drawdown are first-time investors and two-in-five of them consider drawdown as their main source of retirement savings.
It does not come as a great surprise therefore that the government is toying with an idea of introducing a similar default drawdown option for retirees. Interestingly, the way that this hypothetical default is described sheds some light on what that appropriate drawdown solution is in the eyes of our MPs.
We read about the need to reduce complexity, to deal with opaque charging structures and watch out for the risk of moving individuals into unsuitable or unnecessary expensive products. On top of that, the regulator (FCA) is quoted highlighting limited competitive pressure to offer good deals when it comes to drawdown products.
The lessons learnt in accumulation are seen as equally relevant for the post-retirement world and the fees are bound to be high on the government’s agenda. The MP report concludes with the recommendation that the Committee’s remit to “scrutinise value for money in the accumulation phase should be extended to default drawdown products”.
We expect them to become much more outspoken in this space as the social risks are simply too large to ignore. Higher charges in accumulation reduce the final amount of your at-retirement savings but you still have your salary to support your lifestyle along the way. Higher charges in decumulation carry a very different type of risk. They directly impact the chances of you outliving your assets, potentially with no additional income to fall back onto.
One can measure this risk by looking at a "probability of ruin” i.e. the probability of completely drawing down your assets and your investment pot effectively falling down to zero.
We can illustrate that risk in a simple experiment:
- We first assume that today we have £100 to invest in a composite of 60% UK equities and 40% UK gilts.
- Each year we then draw down £4 (in real terms i.e. adjusted for inflation) from our portfolio, in a series of twelve monthly withdrawals.
- We then simulate the future distribution of our investment outcomes under different assumption on the total cost of ownership, ranging from 50 basis points (0.5%) to 250 basis points (2.5%).
- Finally we track the path for the bottom 25th percentile of our distribution – it is not yet the worst case scenario but it is an outcome for which there is not an insignificant chance (namely 25%) that we might fall below that path. In other words, under these assumptions, we have a one-in-four probability of running out of money.
The results are clear. If you face a 50 basis-point total cost of ownership, your investment pot has a decent chance of lasting beyond 33 years. Assuming you retire at 65, there is a one-in-four chance of running out of money before your 98th birthday.
Add another 50 basis points (bringing your total cost to 100bps) and the chances are you might deplete your pot four years earlier. Add another 100bps and you might face a prospect of ruin before you turn 90.
That’s a real risk for one fifth of males and one third of females that the Office for National Statistics expects to live beyond 90 and the government, together with the regulator, seem to be determined to ensure an appropriate consumer protection.
With the final FCA report on Retirement Outcomes Review expected later this year, we expect the spotlight to remain firmly on cost-effectiveness, so watch this space.