Study looks at impact of new retirement choices and warns annuities still important.
Over 1.4 million future retirees are at risk of not having enough income in retirement, according to a new report from the International Longevity Centre-UK (ILC-UK) and insurer Aviva.
The study considered the four main retirement choices people will have from 6th April 2015 when the new pension freedoms, which will offer new flexibility to access defined contribution (DC) pension savings, come into effect.
These are buying an annuity (a product you buy which pays you an income until you die), blowing the lot on big ticket items like a holiday or new car, transferring the pot into a savings account, and using income drawdown (where you leave the fund invested and draw an income).
The report used data from the English Longitudinal Study of Ageing to model the financial impact associated with the choices for those aged 55-74 today and over the next 30 years.
Retirement choices
There are approximately two million people aged over 55 who have yet to retire who have DC pension savings.
The report found that even if all those approaching retirement were to buy an annuity, over half (1.1 million) would not be able to secure a sufficient income unless they have other assets or receive additional benefits on top of the State Pension.
The ILC calculated that, after a tax-free lump sum, the average retirement income would be £12,600 a year. While this is adequate for many, over half (54%) would miss their specific income replacement rates as defined by the Department for Work and Pensions (DWP).
However, in a scenario where DC savings are used to purchase big ticket items, the number not able to get an adequate retirement income unsurprisingly rises by an additional 350,000 to over 1.4 million people in total. After blowing the entire pension pot the ILC calculates the average retirement income (from any State Pension entitlement and workplace pension remaining) would be approximately £9,000 a year or £170 a week.
Transferring the pot to a savings account was also found to be inadequate as people underestimate how long they will live and therefore spread their savings too short. The ILC predicts that, when people have savings they can draw on, they can generate two-thirds of their pre-retirement income which is around £12,000. But once their savings run out they only achieve half their pre-retirement income at around £9,000 a year.
Using income drawdown is also risky. In a balanced fund of 60% bonds and 40% equities, the ILC estimates the average annual income in retirement is initially high compared to other scenarios at £13,500 a year but as the fund runs out average income falls to £9,000.
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The 850,000 most at risk
The ILC says around 850,000 individuals face a higher risk of big income shortfalls from their retirement choices as they have a significant proportion of their wealth locked up in DC pension schemes.
When it comes to their retirement choices their income is more severely impacted by blowing the pot, using a savings account and income drawdown.
The ILC found:
- blowing the pot would lead to a substantial fall in average projected replacement rates – from almost 70% if they buy an annuity to less than 40% if they blow the pot;
- using a savings account could see a fall from a replacement rate of over 60% when they have some savings to less than 40% when savings run out;
- income drawdown could result in a replacement rate of over 70% when they can draw on the fund to less than 40% when the fund runs dry.
The report says this fall in the level of retirement income could mean individuals have to cut back on expenditure at a time when they need it most to pay for basic living and long-term care.
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Annuities still important
Given the impact on those with a high concentration of DC savings the ILC argues that annuities must play a "key role in any future default strategy".
Pension experts fear the complexity around pension choices means many may do nothing with their savings, so a default option is being considered by policymakers.
Last month a paper for the Centre for Policy Studies, for example, proposed the introduction of what's called auto-protection, which would actually default DC members into an annuity at retirement with the option to opt out.
However, as buying an annuity could still be an irreversible decision the ILC says retirees must be forewarned that they will be auto-enrolled into the product and enrolment must not happen until the person reaches State Pension age.
Annuities have fallen out of favour with those about to retire as rates have plummented.
But ILC-UK Senior Research Fellow Ben Franklin said we need to stop thinking annuities as a general rule are bad value for money.
He said: “While we do not advocate that everyone should take a particular course of action, our analysis clearly highlights the benefits of annuitising for those individuals who have a high concentration of wealth in DC savings.
"Annuities are generally misunderstood and the group who stand to lose the most from spending everything too early also score relatively poorly on financial capability, making them particularly susceptible to poor decision making. Without the appropriate support including a new default strategy, these individuals could end up significantly worse-off in retirement”.
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More on the pension reforms:
Pension freedom changes: all you need to know
Government wants to allow sale of annuities