It took about a decade to construct the cross-party consensus, and the support of trade unions and employers, that made automatic enrolment into private pension schemes a realistic prospect. The achievement represents a bold and unprecedented attempt to solve the perceived problem of “under-saving” in the UK, yet in two swift strokes, George Osborne has severely dented one of the foundations upon which the deal rested.
Explaining the significance of what was announced by Osborne in his Conservative party conference speech requires a brief look at some of the crucial, but often excruciating, details behind the compromises that enabled auto-enrolment. It has become increasingly acceptable for employers to refuse to shoulder the risks inherent in collectivised “defined benefit” (DB) pension schemes which usually pay out based on how much you are earning when you retire. In place of DB comes “defined contribution” (DC) provision – a legacy of Margaret Thatcher’s financial sector deregulation – in which employers continue to contribute to our pension pots, but the investment risks are entirely down to us.
Rabbits out of hats
From the individual perspective, DB means you know your pension outcomes in advance. DC outcomes, meanwhile, depend not only on how investments perform, but also on the deal you are able to strike with insurance companies to turn your individual pot into a pension income with an annuity.
Crucially, auto-enrolment was designed in a world in which annuitisation was to a large extent compulsory for DC savers. There were understandable concerns that this led to uncompetitive practises among annuity providers, but it meant that auto-enrolment would eventually create a mass market in annuities, and ultimately drive prices down. Far from perfect in practice, but a workable solution nonetheless.
But earlier this year the coalition government – in another rabbit-out-of-the-hat trick by George Osborne – decided to abolish compulsory annuitisation. This has no benefit to most savers, who have no option but to annuitise their modest savings to secure a lifetime pension income, irrespective of legal compulsion. The measure benefits only the very wealthiest savers, who are less dependent on their pensions saving for their retirement well-being and who would be able to shift their pensions into new investment funds – or buy-to-let housing – when they reached retirement.
Osborne’s latest announcement reinforces that change. At the moment, people are rightly able to bequeath DC pensions pots when they die. But those inheriting these pots are, rightly, heavily taxed when they do, reflecting the significant tax relief that supported the savings being accrued in the first place. From now on, however, these restrictions will be virtually abolished. This has two immediate implications.
Driving up costs
Firstly, it further biases the pensions tax relief system towards the wealthiest savers, that is, those likely to leave inheritable pots behind. Secondly, and most importantly in terms of the economics of pensions provision, it means individuals will be encouraged to keep their savings invested in their pensions scheme.
Whereas the change to annuities would have led to cash being lost to the pensions system, Osborne has argued that the proposed tax change means more people will leave their savings where they are. However, in practice it means they are even less likely to buy an annuity. Just about the only thing encouraging the wealthiest savers to annuitise their savings was the prospect of a large chunk of their savings ending up in HMRC coffers when they died, rather than being passed on to surviving relatives.
In short, Osborne’s announcement means that not only is annuitisation no longer compulsory, but for the wealthiest savers, it is now being significantly disincentivised.
This brings us to the crux of the matter – and the most important long-term implication: all of this makes annuities more expensive. If insurance companies cannot rely on a steady stream of wealthy retirees buying annuities, they lose scale efficiencies and will have to make their products more expensive for the mass market. One of the key building blocks of the historic compromise that convinced employee representatives to accept the riskier world of DC pensions has been hugely undermined – because that world just got considerably riskier.
The wealthiest will argue, of course, that it is unfair to rely on their large pots to cross-subsidise annuity products for the mass market. While logical, this argument overlooks the significant public support that these individuals already benefit from in the form of pensions tax relief. And the fact that auto-enrolment, as originally envisaged, was already bringing down the cost of DC pensions for all savers, including very high earners, due to the new pots being created by low and middle earners.
Osborne has described the current rules on pensions inheritance as a “death tax”, a nonsensical moniker designed to maximise uninformed hoopla among the tabloids – and it duly delivered. But if there are any last rites to be heard today, they are for the hard-fought auto-enrolment consensus that was never given a chance to succeed.