A new study by Age UK reveals growing anxiety among pension providers that retirees do not fully understand the risks of drawdown products – which may lead to a future ‘scandal’. Article by Nick Green.
Pension freedom has yet to face its toughest test, and the consequences could hit retirees hard, warns a report from Age UK. Although the new options for pensioners have proved extremely popular, many people remain unaware of their greater exposure to risk – particular in the case of a stock market crash.
Introduced in 2015, pension freedom gave savers more ways to access their pension pots. This includes drawdown, the ability to leave a pension pot invested in a fund and make withdrawals as required. The advantage of drawdown is having a much more flexible retirement income. But the downsides are twofold: the money can eventually run out (unlike an annuity), and the fund’s performance will fluctuate, depending on how the stock market is performing.
The effect of a market crash on pensions
Around 615,000 people have accessed pensions via drawdown since it was introduced, according to the FCA. During this period the stock market has experienced some turbulence, with several small dips. Accessing drawdown while the market is falling has a negative impact on the fund, as explained in this article – this phenomenon is known as ‘sequence of returns risk’ or ‘pound cost ravaging’. Put simply, it means that drawing from a fund in a falling market makes it harder for the fund to recover later, as it has less capital to work with.
However, the market has not experienced a full-scale crash (such as in 2008, 2000, 1997 or 1992) since pension freedom was introduced. Experts fear that when the next crash happens, as sooner or later it will, tens of thousands of retirees will face a sharp drop in their income, or risk running out of money altogether.
In a statement, Age UK said, ‘Some sort of scandal related to pension freedom may well emerge over the next few years – most likely as a result of a market downturn or a sustained period of poor returns, causing many older people who have not understood the risks of their drawdown fund or who are holding inappropriate investments because of inadequate advice to suffer losses.’
Some pensioners are making unsustainable withdrawals
The charity is particularly concerned about pensioners making higher regular withdrawals. An estimated 90,000 retirees are taking an annual income of 8 per cent or more from their funds. This is only sustainable through periods of very strong growth; even at 6 per cent steady growth, a fund would be exhausted within 22 years, while at a more realistic 4 per cent it would last only 17 years. In reality, of course, growth is not steady, and alternates with stagnant periods and periods of decline. In a falling market, pensioners drawing large percentages therefore run a serious risk of exhausting their pension pots too quickly.
Pensioners using drawdown have the option of pausing or reducing their withdrawals - an action commonly recommended during downturns, if it's practical to do so. However, research by financial firm Zurich indicates that more than half (52 per cent) are unaware of these options. This is also a telling indication of how many retirees may have chosen drawdown without first seeking financial advice.
The Age UK report also reveals the fears of some pension providers (unnamed) who fear that this situation could trigger another national outcry similar to the PPI mis-selling scandal. One said, ‘If I was a provider with a lot of non-advised drawdown customers, the biggest risk is that there is a big fall in the stock market. People will start saying, "What’s happened to my pension?"’.
Retirees losing millions through lack of advice
Lack of advice is also harming retirees in other ways. The government has revealed that its tax takings from pensions are around £2 billion higher than expected, due to pensioners drawing large sums all at once, and/or drawing so much that they pay tax at a higher rate. Around 30,000 drawdown users are also invested in unsuitable assets (such as low-growth cash), while many more (an estimated 150,000) are paying higher fund management fees than necessary, amounting to over £40 million in total.
Age UK’s charity director Caroline Abrahams said, ‘There's no doubt that many are enjoying and benefiting from the greater flexibility they've been given. However, we are worried that a lot of older people ... are making risky decisions that could leave them in a mess in a few years' time.’ Age UK recommends that, as a minimum, people soon to retire should use the government’s free Pension Wise service, often as a prelude to seeking independent financial advice.