Chancellor George Osborne delivers the annual budget in the infamous red briefcase. Source: Oli Scarff/Getty Images.
On Wednesday, UK Chancellor George Osborne stepped out of 11 Downing Street and hoisted a red briefcase for all to see—yes, it’s budget time! Like most pre-election year budgets in the UK, it was full of your standard feel-good measures: beer duty reductions! Lower taxes on bingo winnings! Fixing potholes in Northampton! But in a rare turn for a gridlocked country, Osborne also unveiled a sweeping—and surprising—pension reform plan. Out goes the effective requirement for pensioners to buy an annuity, and in comes flexibility and choice. As with most regulatory shifts, this change likely creates winners and losers. Winners: Investors seeking more freedom of choice. Losers: Potentially, insurers, which face more competition for future business and an adaption to make to the new environment.
Before Wednesday, UK law didn’t explicitly require every retiree to buy an annuity with their pension pot (proceeds from a defined contribution plan, for those not hip on the Queen’s lingo)—it just made life pretty darned difficult (and expensive) if you did anything else. UK retirees could withdraw 25% of their pension balance tax free; the key issue is what happens with the rest. They could withdraw in full at either marginal tax rates or a (crushing) 55% rate, depending on the pot’s size. Or they could draw it down—a non-guaranteed income stream—following one of two complex, heavily restricted plans. Option 1 was capped drawdown, which allowed for withdrawal up to 120% of income paid by a comparable annuity. Option 2 was flexible drawdown, which had no limit but required pension income of at least £20,000 from other sources (like an employer-sponsored arrangement or annuity)—and funds withdrawn are subject to tax at the retiree’s income tax rate. Or, the retiree could buy an annuity—the path of least resistance, which roughly three-quarters of UK pensioners take. Annuities were the long-standing choice from rather restricted menu. Until, that is, the 2014 budget hit.
Per the budget, “From April 2015, the government will change the tax rules to allow people to access their defined contribution pension savings as they wish from the point of retirement.” How nice of them! Flexibility. Among other issues, this allows retirees to invest in the universe of options provided by their financial institution—and we’re betting they’ll provide a few. There is no product prescription; no limited menu of means to distribute your savings. Full withdrawal? No more 55% hit for folks with higher incomes—now, all funds (after the 25% tax free sum) are taxed at income tax rates. Still want an annuity or drawdown? Those remain options. Drawdowns are now easier, with the capped drawdown limit bumped to 150% of the equivalent annuity, while the income requirement for the flexible drawdown falls to £12,000. And the alternative menu is also open to other products.
Why the change? While Osborne’s report claims it’s mostly tied to the increasing longevity of the public, requiring added flexibility, our bet is recent developments in the annuity space likely account for much of the shift. Following a widely publicized report from the Financial Services Consumer Panel, media in the UK has recently been packed with discussions of the complexity of annuities. The report basically called for an investigation into sales practices of annuities, claiming a conflict of interest exists—the insurers make huge fees on their sales, despite the fact they may not be the most appropriate choice for the pensioner. It claimed insurers are earning huge, odious fees—particularly while annuity rates are near rock bottom (another reason the government likely felt compelled to offer alternatives before the election—better returns for retirees!). And it suggested these annuities may not be an appropriate investment for some pensioners. Historically low UK interest rates underpin annuity rates, and with low rates prevailing for years, some argue the government’s requirement was de facto stimulus for insurance firms while hurting retirement savers.
Now the tables are turned. Annuity firms are likely to lose out on future business, and that was reflected by their stock prices on Wednesday. It doesn’t mean they’ll be hit in the here and now—there is no mandate reversing past investment choices and decisions. But it does bring more competition for annuities—and more options for pensioners.
With the new changes, pensioners now have more say in how they invest and live off their life savings—good news when access to your life savings have been rather limited thus far.