Alan Bradbury discusses the recent consultation on small pension pots and examines the issues with the "pot follows employee" approach
The Government has recently announced the results of its consultation on small pension pots and confirmed it favours the ‘pot follows employee' solution.
Clearly there is a major issue with small pension pots. Research undertaken in 2010 by The Pension Tracing Service estimates there is £3billion sat in unclaimed pensions, with one in six workers having no idea where their pension is saved.
Small scale reforms to current systems clearly would not be enough to resolve the problem. Without further action, the future looks even bleaker with auto enrolment potentially creating 50 million small pension pots.
We have over two million customers with legacy pensions, with an average of just £17,000 available to convert to an annuity (after they have taken their tax free lump sum) - against the industry average of £28,000 (after the tax free lump sum is taken).
In addition, research we commissioned earlier this year among our customers found that that one sixth had a pension pot worth less than £5,000 and 19% had four pots or more.
We recognise that holding numerous small pension pots may limit the choices policyholders have. They can find it difficult to obtain independent financial advice and the number of annuities open to them on the open market are reduced.
While the triviality rules provide policyholders with an option to cash the pot in, our research showed that many want the security of a regular guaranteed payment.
The Government has confirmed that initially, the ‘pot follows member' solution will only cover new auto enrolled business - but there is the issue of what to do with legacy business. We believe this issue needs far more consideration.
For legacy, small pot business, we strongly believe it is essential that transfers should only be undertaken with policyholder consent, and preferably on the back of receiving appropriate advice.
It is extremely unlikely that any receiving scheme would pick up the guarantees the policyholders are currently entitled to so any future auto-transfer process could result in a material loss to policyholders through a loss of guaranteed maturity values and guaranteed annuity rates.
We have outlined some examples below of where the policyholder could miss out in an auto transfer process:
Guaranteed maturity values
Many with-profits pension policies provide a guaranteed value at maturity. Whatever happens to markets and interest rates, this amount is guaranteed by the pension provider.
If the pension was transferred before the maturity date, a surrender value would be payable into the aggregator scheme but there would be no guarantee that this would then grow to exceed the guaranteed value that has been given up. There could be a significant risk that the policyholder would be worse off.
Guaranteed annuity rate
Many pension policies may also have a guaranteed annuity rate - which allows the policyholder to convert the maturity value into a pension at a guaranteed rate.
For example, it is estimated that hundreds of thousands of policyholders have a guaranteed annuity and we know approximately 20% of our pension policyholders have a guaranteed annuity rate in force - around 500,000 policies.
This guaranteed rate is far higher than is available on the open market today for healthy lives. A guaranteed annuity rate was a fairly common feature in pension policies issued before 1988, and were provided at a time when interest rates were much higher than they are today, and life expectancy was much shorter.
For example, the rate guaranteed under some older Phoenix Life pension plans is £1 per annum pension for each £10 of maturity proceeds at age 65, giving an effective yield of 10% per annum.
Current annuity rates for a healthy male life are around 5.5% to 6%. A guaranteed annuity rate is often an option that is only exercisable at specified contractual dates, and would be lost on transfer out to another arrangement.
It's also wrong to assume that all policyholders would be happy for the pot to auto transfer. Our research showed that 25% would not want to combine their pension pots, even if the option was available.
We support the Government's ambition to take action to ensure the future pensions system works in the interests of individuals.
Automatic enrolment has the potential to fundamentally improve UK pension provision and to begin to tackle the savings gap but it's vital that any changes to current systems safeguard policyholders' interests.
Alan Bradbury is head of annuities at the Phoenix Group
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