Ending Compulsory Annuitisattion - What are the consequences?

Annuities protect individuals against outliving their resources for however long they live. Nevertheless, they are also inflexible once purchased and consumers tend to avoid buying an annuity if they can do so voluntarily. Three reasons have been put forward to explain this: consumers’ low levels of financial literacy; consumers’ poor understanding of longevity risk; and behavioural biases resulting in consumers making inconsistent or irrational decisions. Yet there is evidence to show that the advantages of annuitisation outweigh the disadvantages.

A number of reasons have been put forward to justify compulsory annuitisation: it avoids selection effects; it has lower administrative costs than in voluntary annuity markets; it avoids moral hazard problems; it is the quid pro quo for tax relief on pension saving; and prevents the pension system being used for tax avoidance.

If pensioners choose not to buy annuities, they face a range of risks and costs associated with running down their retirement savings, including: longevity risk, investment return risk; costs of managing pension wealth; and the risk of making mistakes. They may mis-manage their pension fund either due to a lack of understanding or because of behavioural biases. They might also be sold unsuitable investments.

There are a number of potential risks to the public purse from removing the annuitisation requirement for DC pensions. First, there is the impact on meanstested state benefits, since pensioners who run out of funds will fall back on taxpayers for support. Second, there may be an impact on defined benefit pensions. An unintended consequence of allowing DC pensioners to avoid annuitisation is that it may encourage DB scheme members, including public sector workers in unfunded schemes, to lobby for their pension to be received as a lump sum rather than as an income. Third, there are the consequences for tax avoidance. Fourth, there are the impacts on government and other long-term bond markets.

The Government proposes to deal with the impact of ending compulsory annuitisation on means-tested benefits by requiring annuitisation up to a minimum income requirement (MIR). However, there are a number of problems in calculating such a minimum annuity purchase. It is difficult to predict the environment in which the means-tested benefits system will operate a long way into the future. The state benefits system is complicated and the precise amount that needs to be annuitised will depend upon individual circumstances and will affect and be affected by means-testing. There is an issue of how to treat couples fairly. There is the difficulty in creating appropriate annuity products to avoid receipt of means-tested benefits over a lifetime. There is also the difficulty in matching pensions to inflation when a number of different definitions of inflation (RPI, CPI, LPI and increases in national average earnings) are in use.