PENSIONS REFORM – DC ONLY OR IS IT?

Last week on Wednesday, the Chancellor announced the 2014 Budget. Although, according to the FT, in the run-up to the publication there were hints that George Osborne might “pull a rabbit from the hat”, not many had expected the kind of pension reform bombshell the Chancellor dropped.

What Happened?

In essence, the new law makes it possible for the Defined Contribution (“DC”) pension scheme members to withdraw their entire pension pot all at once upon retirement, without incurring a highly punitive tax, as it was the case so far. Before the change, the system was relatively inflexible and complex. The options faced by DC members upon retirement under the old and the new regulation are summarised below:

Before the Reform:

After the Reform:

Source :
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/293759/37630_Budget_2014_Web_Accessible.pdf
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/293743/budget_2014_greater_choice_in_pensions_explained.pdf

 
In addition to the above, there is another set of rules that will apply in the 2013/14 fiscal year only. These are based on the old law but most limits have been relaxed. Small pot limits have been revised from £2,000 and £18,000 to £10,000 and £30,000 respectively. The £10,000 small pot rule can now be applied three times per individual instead of just two. The capped drawdown rate has been increased to 150% of an equivalent annuity and minimum guaranteed income requirement to qualify for flexible drawdown has been set to £12,000 p.a., down from £20,000 p.a.

Winners and Losers

Under the old system, the majority of people (about 3/4 in fact, according to the HM Treasury), chose to purchase an annuity. Under the new, more flexible rules, pensioners are free to move their retirement savings effectively to any other investment solution (or, in extreme case splash out the entire sum on a shiny new Lamborghini as some cynically hint). As interest rates have fallen over the last few years, annuity rates have become less attractive. Having had limited room for manoeuvre so far, pensioners were forced to accept the pricing. However, now that individuals are free to invest the money as they see fit, it would be reasonable to expect that the new reform will result in at least partial loss of business for the annuity providers (which is indeed market expectation, as most of them saw their share prices dropping substantially after the reform has been announced). It is also expected that annuity providers, now facing more competition, will revise the rates and terms offered to maintain some of the sales. The beneficiaries of the reform are likely to be retail investment solutions providers, such as wealth management firms and ISA providers. Some new market entrants might emerge and products enabling flexible income drawdown might become available.
 
Needless, to say, among the winners is also the government itself, which is likely to see more tax coming in the near future as pensioners pay marginal income tax on the lump-sum withdrawals.
 
Implications for DB Pension Schemes

Although technically the reform only regards DC pension schemes, there are a number of channels via which Defined Benefit (“DB”) schemes might be affected:

1. Given the reform, it might be perceived as attractive to switch from a DB to a DC pension scheme. This could have a profound effect on DB pension schemes, the vast majority of which are currently unfunded. The effect is likely to be positive, reducing both the deficit and the liability values. Although the Budget is clear with respect to the treatment of the public sector DB schemes (where such transfers will effectively be banned), it gives less colour on the private sector schemes. The Budget says “(…) whilst in principle it [the government] would like to permit transfers from private sector defined benefit schemes under the new freedoms, it will only consider doing so if the risks and issues around doing so can be shown to be manageable.” The government will consult on how best to implement the reforms and more clarity around this issue is expected in the oncoming months.

2. Annuity providers, in anticipation of a substantial decrease in retail sales, might seek the DB scheme buy-out business to make up for at least part of the loss. This means that the providers might seek to relax the bulk annuity terms, effectively making more DB schemes eligible.

3. If annuity business is indeed to shrink, it should be expected that the demand for assets that annuity providers typically invest in should fall accordingly. The obvious candidates are corporate bonds and income generating illiquid assets, such as infrastructure debt. Defined benefit pension schemes, who also allocate to these assets, could therefore be potentially affected via pricing. In addition to this, lower market participation in these asset classes is likely to create more opportunities for other investors to explore.
 
It is however, far from clear what the ultimate destination will be for DC assets in drawdown, and the answer to that question may have profound implications for markets and investors more generally in the years to come.

Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.

 

Author: Kate Mijakowska

Kate joined Redington as part of the Manager Research graduate team in 2011, and now works with senior members of the Manager Research Team to provide advice to a range of trustee and sponsor-side clients. Kate holds a BSc degree in Economics from Sussex University, as well as a MSc in Real Estate Economics and Finance from the London School of Economics.