How to build the pension income builder
News analysis: Industry experts have been exploring how the government’s preferred risk-sharing scheme design could work in practice, whether through a not-for-profit, mutual or insurance provider set-up.
In December, pensions minister Steve Webb and Alan Rubenstein, chief executive of the Pension Protection Fund, revealed their preferred structure for risk-sharing was the pension income builder.
European regulation
There are three structures that can be used to provide pension benefits, under European Union rules:
- Insurance company.
- Sponsor-supported pension scheme.
- Regulatory own funds.
Only the third type is not currently used in the UK, though the government has the power to lay the regulatory foundations.
Under this approach, a proportion of pension contributions would be used each year to buy a guaranteed pension income, allowing a set future income to build while the rest is invested collectively.
“What I like about the product is that you have a pot that is guaranteed and another part that is return-seeking,” said Stefan Lundbergh, head of innovation at fiduciary manager Cardano, which worked with the government on its proposals to reinvigorate workplace pensions.
But in order to have the scale to get value on these annuities from inside the scheme, the pension income builder would have to be housed within something with adequate seed capital, whether that is an insurance provider, a government-sponsored not-for-profit organisation like Nest, or a mutual. “The question is how you get the mutual started,” said Lundbergh.
Under this approach, the member would not be buying a deferred annuity from the insurance company. It would have to be set up under a different legislative framework, which would remove some of the costs that insurers have, as well as providing the possibility for lower capital requirements.
But those working on the plans admit running costs would be closer to defined benefit than defined contribution due to the complexity of the investment governance and administration needed.
It had previously become unviable for insurance companies to offer deferred annuities due to the capital required to cover two primary risks: life expectancy and reinvestment risk.
But there is a possibility the product could be rekindled for the pension income builder approach, according to Mark Wood, CEO of JLT Benefit Solutions. The incoming Solvency II legislation has reduced the capital demands on annuity writers, feeding through to better prices, together with the certainty provided to members.
“You immunise yourself from the exposure to the economic conditions at the point at which you retire,” Wood said. “You remove the risk of inflation, life expectancy and investment return at the point at which you buy the annuity.”
But the twin risks of life expectancy and higher inflation from the unwinding of quantitative easing could keep the pricing of deferred annuities unattractive for a while, Wood added.
Denmark’s ATP scheme is one example of a self-annuitising scheme. It uses 80 per cent of member contributions for fixed annuity-style income and 20 per cent invested in return-seeking assets that could be used for inflation protection.
It is thought the government would leave it up to any UK scheme to set the balance between the assets set aside for guaranteed income and protection from price rises.