WITH the demise of salary-related pensions, we now face the challenge of ensuring people get the most out of the alternative defined contribution system, where their pensions are heavily dependent on how much they have saved during their working lifetime.
This is why pensions minister Steve Webb is right to worry about annuities. But his latest proposal to allow people to switch annuity providers, much as they can switch mortgages, is the wrong answer and only addresses part of the problem.
If pensioners are getting a bad deal out of their annuities because of hidden fees, poorly-explained conditions and a general lack of transparency on the part of providers, Webb should deal firmly with the obfuscation. There really is no excuse for it. The deeper problem, however, is that annuities are at best an over-rated product.
An annuity offers pensioners a guaranteed income for life, in return for which they must sacrifice the capital they have saved. That would be fine if annuity rates were generous. But partly because of current low interest rates and, importantly, because they consume a lot of expensive insurance industry capital, annuity rates are very low.
The current rate from an index-linked shared life annuity for a couple, where the man is 65 and the woman 60, is around 3 per cent. Compare this with the dividend return of 3.1 per cent the same savings could generate through an investment in the FTSE AllShare index. If that couple were able to put their pension pot into the AllShare, they could get both comparable income and keep all their capital to hand on to their heirs.
Dividends, of course, do not provide a perfect match for inflation and do not always go up in linear fashion. But over time and over the market as a whole, their rise tends to outpace that of consumer prices, and they are certainly much less volatile than share prices themselves.
The ability to switch annuity providers, which Webb proposes, would exacerbate the problem of low annuity rates, as providers would face the large cost of unpicking investments undertaken to match their original commitments. Perhaps Webb should instead offer greater choice to retirees. Instead of compelling them to put their money into annuities (or to adopt complex income drawdown arrangements that are not suitable for all), he could open up a new opportunity for some or all of even small pension pots to go into an index-tracker fund, with the proviso that the capital could not be drawn down except to fund long-term care.
Insurers would almost certainly resist this, because their business models are so heavily orientated towards the provision of annuities. But opening up choice further would not only give pensioners a greater chance of having something to hand on to their children. A new focus on long-term dividend provision might also make listed companies less short-term in their outlook. And a bit of competition might even inject some useful discipline into the way annuities are sold.
Peter Montagnon is associate director of the Institute of Business Ethics.