Employers are paying more attention to pension decumulation to help staff understand the options in the run up to retirement, says Matthew Craig
Ensuring pension scheme members save enough for their retirement may be the main concern for employers and pension trustees, but there is also growing interest in pension decumulation – the process of taking an income from a fund.
This is partly because the nature of retirement is changing from being a ‘cliff-edge’ event, with a complete halt to paid employment, to a more gradual shift over a longer period. This is being driven by government policy, which now permits flexible retirement where a mix of pension income and earned income is taken, and wider demographic, economic and social factors, such the rise in life expectancy, the maturing of the baby boomer generation and declining annuity rates.
Another reason for employers and staff to focus on pension decumulation is scheme members now have more choices than before. Decumulation tends to be associated more with defined contribution (DC) schemes, where members accumulate an individual pot they can access at retirement. However, it could also apply to defined benefit (DB) scheme members who choose to transfer out before retirement. Pension decumulation raises issues such as whether to purchase an annuity or to use the unsecured pension rules (formerly known as income drawdown) to draw an income from a pension fund instead. Other issues include spouses’ and dependants’ benefits, not to mention the different types of annuity on offer.
Pensions Regulator guidance
Given the importance of decumulation, is not surprising The Pensions Regulator issued regulatory guidance to trustees and employers on members’ retirement options last November. Its research had found little information was generally available for employers and trustees on the practical and operational issues they faced around decumulation. The regulator is therefore encouraging trustees and employers to think carefully about the retirement options offered by their schemes and to follow good practice. It also wants trustees and employers to emphasise to members the advantages of getting financial advice from a suitably qualified adviser.
When considering pension decumulation and the messages given to staff, employers should bear in mind three main points, says Stephen Hart, legal director at law firm DLA Piper. “Firstly, employers can give information but must not give advice, because this can only come from an independent financial adviser.
“Secondly, when giving information, there are lots of options on which to take advice. Employers should talk to staff early on, probably when they are in their fifties, about considering when to take their benefits.”
Others agree decumulation is a subject that should be raised with members earlier rather than later. Adam Stevenson, senior consultant at Towers Watson, says employees should start thinking about pension decumulation about five years before their planned retirement date. “Members should think about where they are invested,” he explains. “They might want a different investment strategy if they are not planning to buy an annuity on retirement.”
But Roger Breedon, principal at Mercer, says this topic is not currently being addressed well. “Improvements need to be made here. It is really important to start thinking about retirement five to 10 years out for a member’s investment strategy.”
One incentive for employers to meet the challenge of preparing members for retirement is that it may have good repercussions throughout the workforce, for example if staff attend pre-retirement seminars. “The attendees come back and say they now feel more armed to think about what they need to do,” says Towers Watson’s Stevenson. “There is a positive message in the workplace about their employers’ support for them at a difficult stage.”
Maximise annuity income
One important issue for many DC scheme members is maximising their annuity income. Here, The Pensions Regulator has pointed out the benefits of members knowing about the open market option (OMO), which means retirees can buy any annuity from any provider to get the best rate. Information about the OMO can be communicated to scheme members in a number of ways. Andrew Cheseldine, senior consultant at Hewitt Associates, says an online tool can be useful. “Members can do online modelling, looking at the shape of annuities, so they can decide what kind makes sense for them.”
Many employees miss out on a higher annuity rate by not purchasing an impaired life or enhanced annuity, which pays out more to people in poor health, or if they have a less healthy lifestyle because they smoke, for example. “About 40% of the population could get improved terms on their annuity, but three-quarters of them do not,” says Cheseldine. “A simple communications exercise could mean retiring employees get more money for the rest of their life.”
As well as conventional, impaired life and enhanced annuities, there is now a selection of more innovative retirement income products that offer members a mix of investment- linked returns and guarantees, as well as an unsecured pension. These allow staff to keep their pension fund invested, with an income taken. It is also possible to use a mix of these approaches to pension decumulation, making this area very complex. “Individuals ought to go to an IFA to talk about these options,” says DLA Piper’s Hart. “HR managers should tread carefully and not step over the line between giving information and offering advice.”
More IFAs are recognising the increasing importance of the transition to retirement, which should help members and employers seeking advice, says Ann Flynn, head of marketing communications at Scottish Widows.
There is currently a growing appetite for employee counselling services and webcasts to increase awareness of retirement issues, says Towers Watson’s Stevenson. “Communication is an integral part of this and we are seeing more involvement by employers and trustees. Having an annuity broking service can help members maximise their annuity income. It is an education process and there are lots of lessons to be learnt. Trustees and employers need to be aware of it.”
Decumulation should therefore be seen as the second part of the pension equation for scheme members, following the accumulation period. What were once rigid boundaries between the worlds of work and retirement are now blurring and, by opening up a new path for scheme members, the decumulation process will become increasingly important in the future.
Pension decumulation: practical issues
1. Communication for contract-based defined contribution (DC) scheme members
Pension providers can assist employers with communication around decumulation for members of a contract-based DC plan. Ann Flynn, head of marketing communications at Scottish Widows, says: “From a regulatory perspective, we have to communicate with people before retirement. Six months prior to the chosen retirement date, we will send information about [a member’s] options if they are going to retire.
“Members need to be told they can go out and use the open market option. Six weeks before the selected retirement date, we send out a more formal annuity quotation, highlighting what they will get from us if they do not go to the open market.”
2. Pension benefits and means-tested benefits
Some pension scheme members with small amounts of pension savings can take the entire sum as cash under trivial commutation rules. If an individual has aggregated pension benefits of less than 1% of the lifetime allowance, or £17,500 for 2009/10, this can be taken as a lump sum.
While this is attractive to many, it may not always be in their best interests, says Andrew Cheseldine, senior consultant at Hewitt Associates. “Quite a few people can go without buying an annuity, but the very people that are affected are also likely to be subject to means-tested benefits. For example, a 65-year-old with £10,000 in a DC scheme could get that as a lump sum, with 25% of it tax-free.
“If the rest is taxed at the basic rate of 20%, they will get £8,500 in total. That is enough money to put them over the threshold for means-tested benefits, so [employers] have to be careful. They might think they are doing a member a favour by giving them a lump sum, but the [employee] may end up out of pocket.”