Source: Flikr Creative Commons by Thomas Galvez under license

Patrick Collinson’s article about bringing in auto-annuitisation and a national annuity service has prompted some discussion.

As he said:

It won’t solve the problem of overcharging by the City while workers are saving to build up their pension pot. It won’t solve stockmarket underperformance. It won’t solve the biggest issue for annuities – that we are continuing to live longer and longer. But a National Annuity Service could at least make sure that one of the biggest financial decisions anybody faces isn’t a case of pension pot luck.

Peter Kane, Corporate Relationship Director at Standard Life, felt that the biggest challenge was that most employees in the UK are not saving enough and the average level of fund at retirement (before an annuity is even considered) is insufficient. He’ll get no argument from anyone about that being a big challenge, but there has been a great deal of discussion about it and there will continue to be so. It does not in any way diminish the importance of what he refers to as “the annuity issue”.

Matt Dorrington, Pension Consultant at Capita Employee Benefits, thinks what we need to consider is who will hand hold these people and how are they remunerated for their services. The reason a national annuity service would be set up of course is if the Government decided that the pensions industry was not hand holding enough and requiring to be remunerated too much.

Joe Robertson, Member Nominated Director at The Pensions Trust, was concerned about the computerisation required to process the information to allow enhanced annuities for the masses. Is that why there has been so little encouragement to people to access the much better value annuities their personal information could buy them for so many years (up to 24% of annuities were enhanced in some way in 2012, but only 2% were in 2003)?

If the Government were to step in with a cheaper annuity advice and broking service, would this lead to commercial annuity brokers leaving the market, or to their charges coming down to closer to the state broker’s rates? Commercial brokers might well still offer a wider range of options, justifying higher fees. If auto-annuitisation only applied for pension funds up to a certain level, with funds above this level not needing to be surrendered to the national service, might there still be a market for advising high net worth individuals?

These are just some of the many questions which would need to be answered, but such a service could potentially significantly improve outcomes for many. If nothing else it could reduce the current very wide variation in outcomes, although this may of course lead to those who currently navigate their way around the system quite cannily ultimately being worse off.

I would like to see an additional service provided by the new broker if it ever came into existence: to index market annuity rates against the relative cost of annuities under the Pension Protection Fund’s (PPF’s) Section 143 basis in any given month (this gives the amount of money the PPF currently requires schemes to have to purchase an annuity when their sponsor has failed so as to avoid entry into the PPF). Obviously even standard annuity rates vary by postcode, but it would provide a check on market prices increasing beyond what movements in the underlying investments used by annuity providers would justify.

But of course the real problems are at the bottom end. According to the Association of British Insurers (ABI), 30% of annuities were purchased with less than £10,000 in 2012. For annuities purchased with £20,000 or less, this percentage increases to nearly 40% for external annuities (ie when people “shop around”, as apparently they now do in 48% of cases) and nearly 60% for internal annuities (when they don’t).

Why is this, when legislation allows people to take the first £18,000 of pensions savings as cash (the so-called “trivial commutation” rules)? Part of the answer may lie in the latest report from the Pensions Institute entitled How do savers think about and respond to risk?. Of particular relevance I think is this finding:

One clear preference stands out: the reluctance to dip into long-term savings to meet a shortfall in short-term savings goals and vice versa. This provides support for the idea from behavioural finance that people have different “mental accounts” for their savings goals and are reluctant to “borrow from” them for other purposes (ie the mental accounts are not fungible). This holds very strongly for the long-term fund: only as a last resort are most people prepared to dip into this to meet short-term savings goals. A slightly bigger percentage of people are, however, prepared to use their short-term fund if they face the risk of a shortfall in their long-term savings goals.

I think at least part of the reason for the high demand for small annuities is this unwillingness to convert money which has always been seen as long term savings (and for which, as another part of the report makes clear, most people are generally more willing to accept a lower, but more stable, income than to risk significant falls in the asset value) into a form which could end up meeting short term needs instead. Of course, part of the reason might also be lack of awareness that the option not to buy an annuity exists. A state broking service may therefore help here too.

In view of the particularly poor value offered in the market at the lower end (£5,000 buys you around £5 a week, not increasing and which does not include anything for your spouse) and the persistent demand in spite of this, I would like to propose one further step. I think the Government might want to consider creating a section of the PPF for small pots. Say, those up to £18,000?

It is in no way what the PPF was set up to do. And yet. The administration expertise with handling large volumes of small pensions is already in place there. And, if the terms offered were on a S143 basis, it should not create any additional funding burden. What ever they make think of it, employers with pension schemes have become accustomed to dealing with the PPF.

If the PPF were able to take small pots on similar terms to those currently only available to larger annuities in the market, and the market were then left to provide annuities for everyone else, outcomes might be improved at all levels.

The PPF as an annuity provider of last resort? Perhaps this is an idea whose time has come.