Pension Provision is Best Done Collectively
Annuities have their advantages but the current system is a mess
As the old actuarial joke says, the English actuary will calculate on average when we are going to die but the Sicilian actuary will give us the time, date and place. The problem for most of us is of course that so few of us know exactly when we will die and, unless we are very rich, whether our savings will run out before we do. This is why the emergence of specialised gambling contracts, known as annuities, 300 years ago was so useful for most people. Rich people know they will have enough to live on whatever happens; poor people just have to get by; but the middle classes sweat over whether they and their family have enough to live on until they expire.
And the chances of funds running out too soon are higher than they have been. There is a double whammy: first, life expectancy is increasing so fast that every day that goes by we can expect to live another six hours. And secondly, the investments we put our savings in nowadays give an unpredictable and fluctuating level of income and security. Most recently quantitative easing has pushed interest levels to an unprecedented low, so that annuity rates offered by the counterparties to the gambling contract, the insurer, are lower than had ever seemed possible.
So no wonder people have been complaining about annuities. And it’s understandable that a government facing elections looks to a small bout of populism to garner a vote or two — and to raise some cash to benefit the Treasury as well. The announcement in the Budget that the penal taxation on taking money out of a pension pot is being reduced to simple high taxation might therefore look attractive — but common sense and bitter experience suggest there could be tears by teatime.
Wealthy people hate annuities; they see the pension pot as just that, a pot of money, rather than a stream of future income. They think the insurers rob them. And they think they can invest better themselves, although the real reason that annuities seem poor value is that regulators and the government insists insurers invest in government securities at a time of quantitative easing, i.e. they are forced to invest in awful investments.
But there are advantages to annuities. They allow us to share risk: the actuaries know, on average, how long a group of people will live, which means we as individuals do not need to save in case we live to 120, which would be expensive and wasteful. They are cheap, popular myths to the contrary, since despite all their faults insurers can invest better than an individual can. And, incidentally, they give immunity from bankruptcy.
Some things, like national defence, are best done collectively, and one of those is annuitisation and pension provision. The removal of the requirement, after 70 years of consensus, that if you save money for your old age you will enjoy fiscal neutrality on that money is based on a false premise, i.e. that pensions are the same as savings. It is supported by an unrelated issue, namely an unthinking dislike of public sector pensions (what will we do with the underpaid nurses who can’t afford to make their own provision for retirement?). The removal of the annuity requirement militates against two accepted elements of public policy: first, the fiscal deal that there will be tax neutrality on pension arrangements in exchange for protecting ourselves against old age; and second, the nudge principle, that the state will direct us into a sensible decision by default, one we can undo if we insist.
Auto-enrolment into pensions, now being rolled out nationwide, is based on nudge theory. But just as we nudge people to make sensible decisions on pensions at the start, we are nudging them out of them at the end. If we really did believe in giving people the power over their own money, we wouldn’t force them to save for their old age in the first place. It is contrary to the nudge principle to allow us to spend pension money as and when we retire.
So it looks as though the reduction in tax for cashing in annuities (which makes it advantageous to take the cash) is prompted more by populism and the need for tax than by sensible public policy. Annuities have now been all but destroyed by a perfect storm of government need for cash (the government will get just under half the sum that people cash in), government regulations affecting what annuities can be invested in, and the forthcoming expensive and unnecessarily draconian imposition on insurers to increase their reserves. The paradox is that all this is happening at a time when we are not being allowed to borrow money on mortgage unless the Financial Conduct Authority says we can afford it, although we can borrow as much as we like from credit cards and Wonga.
Being forced to buy an annuity is not a consequence of a nanny state; it is part of the fiscal deal to distinguish pensions from savings. And being forced to buy an annuity is not a present for financial institutions; there is a market out there even though it is distorted by inappropriate government regulation.
If pensions still exist in ten years’ time, we will introduce new rules to protect us from being stupid with our own money, which experience suggests around a half of us will be. Companies will retreat even farther from pension provision if the funds they provide can be used for cash rather than for pension. There will be articles in the Daily Mail about the lump-sum scandal. And there will be a better understanding of the collective sharing of risk.
What a mess. And all because we have confused libertarianism with nudge theory. The argument for annuities is not that we don’t trust people to manage their own money. It is that it is not money they are supposed to be managing but their life expectancy. And as the English actuary well understands, no one can do that on their own.