Breaking through the barriers to post-retirement investment

Elizabeth Haggis, principal of Excuria Law, analyses the recent Financial Conduct Authority (FCA) interim report on retirement income which focused on the behavioural barriers to effective post-retirement investment by consumers and providers alike.

Original news

Retirement income market review confirms FCA’s concerns, LNB News 11/12/2014 154

An FCA retirement income market study has confirmed its concerns that competition is not working as well as it could be for consumers, with many continuing to miss out on higher income by not shopping around. However, the regulator’s analysis also suggested that for people with average-sized pension pots and low risk appetite, the right annuity purchased on the open market offers good value for money relative to alternative drawdown strategies. The FCA has made a series of recommendations, which take into account the pension reforms announced in the 2014 Budget, in particular to improve the way firms communicate with customers about their options.

What is the background to the market study and Thematic Review 14/20?

The FCA published an interim report on retirement income in December 2014 (see Retirement income market review confirms FCA’s concerns LNB News 11/12/2014 154). This 102-page document follows on from:

• a thematic review of annuities, and
• revised terms of reference, in light of the 2014 Budget changes, for a market study to assess whether competition in the retirement income market is working well for consumers and, if not, why that is the case—RIMS arises from these amended terms of reference

A word of caution: RIMS refers specifically to ‘8 million members of personal and stakeholder pension plans in the UK’. Earlier studies refer to people with ‘[defined contribution] DC pension pots’. Therefore, it is not immediately clear whether it is intended to refer to all DC scheme members, or limited to members of contract-based DC schemes. Given the fragmented nature of the regulation of DC pensions, which depends largely on whether the originating pension vehicle is contract- or trust-based, it is likely that RIMS can only deal with contract-based DC consumers—ie members of personal and stakeholder pension schemes. The references to ‘consumers’ assumes the individual will purchase the annuity/drawdown. In trust-based DC schemes, it is usually the trustees’ advisers who obtain the annuity quote or quotes at the point of retirement.

What are the FCA’s main findings?

The findings are provisional at this stage. The FCA requested comments on RIMS’ provisional findings and proposed remedies by 30 January 2015. Once it has considered consultation responses, it will produce its final report on an as-yet unspecified date in 2015.

The report is long and complex. Therefore, the FCA’s findings will only be outlined here.

Too many consumers purchase an annuity from their existing provider without shopping around to see what would be available to them on the open market. 80% of consumers who purchased an annuity from their current provider could get a better deal in the open market. This figure rises to 91% for enhanced annuities.

‘Shopping around’ covers a broad spectrum of behaviour, ranging from briefly looking for information in the press or online to obtaining comparative quotes or going to one alternative provider with a strong brand reputation.

There are a number of reasons for not shopping around. These include:

• difficulty in understanding where to start or how to go about finding out information, particularly among those with limited confidence in using the internet
• reluctance to committing the time/effort involved, particularly where DC pots account for a relatively small proportion of retirement income
• unfamiliar and off-putting terminology and jargon
• unwillingness to provide detailed personal information, particularly online where the site is unknown
• trusting in ‘experts’—typically, knowledge is limited and shopping around unlikely where employers and independent financial advisers (IFAs) are involved in the process
• major life events such as ill health, redundancy, where time is the key factor in decision-making

In addition, the complications and costs inherent in the shopping process relative to the perceived value can be further deterrents. Effective searching involves approaching brokers and providers directly and brokers are not always clear which providers they have arrangements with. The uplift may only amount to, perhaps, £1.28 per week, which is not a great deal but which could provide the average annuitant with an additional £1,500 over their lifetime. Consumers tend to discount what they perceive to be small uplifts.

Furthermore, some consumers make an active decision to stay with their existing pension provider. The reasons for this may include:

• loyalty to the existing provider
• belief the likely uplift would not justify the effort involved in shopping around, without considering the long-term impact on their retirement income, and
• value placed on a trusted brand when shopping for a lifetime product

Consumers often make intuitive decisions, rather than reaching decisions in a rational way, based on all available information. Intuitive factors include:

• the complexity of the retirement income decision
• the one-off nature of the decision and the fear of making mistakes that cannot be rectified
• trading off between present and future—for example, most consumers are aware of the dangers of inflation, but are unwilling to pay the price of inflation-proofing their retirement income in return for a lower initial pension payment
• overconfidence in assuming that their retirement income will cover their needs—this includes such factors as underestimating total income required and longevity
• more concern about avoiding loss than making gains—for example, consumers approaching retirement are more concerned about losing annuity funds through dying early than gaining annuity funds by living longer
• susceptibility to the way information is framed—consumers presented with the same information, but framed differently, make different choices
• the 2014 Budget changes—increasingly, consumers are showing preference for drawdown to annuities, despite the cost and risk associated with drawdown and the main reasons for this are:
  • dislike of losing the pot on early death and the inherent inflexibility of annuities
  • desire to adapt to changing circumstances
  • desire to have more control over their money, and
  •  mistrust of providers

What are the FCA’s main proposals?

In broad terms, these are set out below.

Consumer guidance and information

Firms will make it clear to consumers how their quote compares to other providers on the open market. The FCA proposes this could be provided by (for example) the Money Advice Service annuity comparison website to generate alternative quotes for a particular consumer from other providers operating on the open-market, based on certain characteristics—age, pot size and some specific health conditions.

The FCA recommends that the pension guidance service and firms take into account ‘framing effects’ and other biases when designing tools to support consumer decision-making. Options should be presented in such a way that they support good decision-making. In the longer term, recognising there will be continual improvements to the guidance service, consideration should be given to ‘appropriate framing’. This includes the use of behavioural triggers, such as a rule of thumb to use when withdrawing funds through drawdown and triggering uncrystallised fund pension lump sums. The intention is that the result will be a simple guideline for consumers to counter known biases around risk appetite and longevity.

Wake-up pack alternative

The FCA will work with government to develop an alternative to the current wake-up pack that consumers receive from their plan provider before they reach their chosen retirement date and at 12-monthly intervals thereafter, should they decide not to take pension benefits. The wake-up pack is compulsory. New ‘at-retirement communications’ should be behaviourally trialled to make them as effective as possible in prompting shopping around and signposting impartial guidance. The FCA also proposes replacing the compulsory Association of British Insurers (ABI) Code of Conduct with its own rules.

Pensions dashboard

In the long-term, the FCA has recommended the development of a pensions dashboard from which consumers will be able to view all their lifetime pension savings, including other sources of retirement income such as defined benefit and state pension entitlements.

The FCA will continue to monitor the market as it evolves and may take steps if, for example, it sees competition is weakening and inappropriate products, distribution arrangement and charging structures are emerging. It will also continue raising consumers’ awareness of investment and pension liberation scams.

What actions will firms have to take because of the proposals?

The FCA expects to see innovative products, albeit recognising that it is still too early to tell how the market will evolve. The key drivers will be:

• consumer demand
• product innovation

Consumer demand

The government’s reforms on decumulation will provide consumers with increased flexibility, which will in turn drive demand for new products.

Product innovation

There could be developments to certain products, such as:

Lifetime annuities with more personalised underwriting for internally vesting and open market option customers

This is an expected outcome of insurers’ desire to manage adverse selection against annuities, which consumers generally perceive as poor value for money.

Managed drawdown

Take-up of income drawdown products is expected to increase. Mass-market drawdown products are expected to include those offering a limited selection of funds to choose from (for example, three to five) on a predominantly execution-only basis direct with consumers.

Hybrid guaranteed products

Research shows consumers value products that provide an element of guarantee. Existing products, such as fixed term annuities, investment-linked annuities and variable annuities are expected to be re-launched under different branding and a modularised pricing structure. While these products have been available for some time, they have not traditionally been aimed at the mass market.

Blended solutions

These include, for example, combining annuities to cover living expenses with drawdown that exposes the consumer to investment growth and risk. In addition, products could operate back-to-back, eg drawdown while income needs are flexible, followed by an annuity later in life to provide the security of a guarantee.

Consumer-orientated innovations

To complement the pension guidance service, consumer-orientated innovations are expected, initially focused on the following areas:

• direct to consumer business models, involving interaction with potential customers approaching and throughout the retirement journey
• digital customer engagement—most firms already provide online digital tools and guides for consumers and the FCA expects firms to develop ‘a more holistic digital proposition’ for consumers going forward in order to digitise the wider pension lifecycle and customer journey towards, at and through retirement
• retirement advice—for those consumers who do not have access to individual wealth and financial planning the FCA expects some providers to offer direct advice services, in addition to the pension guidance service

What should lawyers be advising their clients?

At this stage, there appears to be little that lawyers can offer their clients in terms of definite advice about future developments in this area. RIMS focuses on the behavioural barriers to effective retirement decumulation, by both consumers and providers, and the expected behavioural outcomes following finalisation of the report in 2015.

Consumers do not tend to seek legal advice during their retirement process and, ordinarily, should not need to. The Pensions Regulator currently regulates DC trustees and the FCA has limited involvement with trust-based arrangements, although trustee advisers frequently are FCA regulated.

The Pensions Regulator’s website offers limited guidance for DC trustees. This includes the requirement to have a retirement process that helps members to receive a good outcome from their pension savings. The process should ensure trustees start communicating with members a number of years before they retire and it should set out the key activities, timeframes and who is responsible for them. It could include the following stages:

• ensuring members understand retirement
• ensuring members understand the different ways to take retirement income
• ensuring members understand how to buy products
• implementing members’ decisions
• reviewing the retirement process and monitoring outcomes
• ensuring the process enables trustees to act without delay and that they make members aware that they need to act promptly

This guidance is not mandatory, whereas the rules and guidance emerging from the FCA in due course will be.

Interviewed by Evelyn Reid

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor