As those in the UK will know, one of the major changes announced in the recent budget was to ‘free up’ defined contribution pension schemes so that recipients were no longer forced to buy an annuity with their pension, but could instead take the cash sum and spend or save it how they liked. This has been generally praised by our predominantly neoliberal press. The government’s line that this was a budget for savers and pensioners has been accepted uncritically. Giving people the choice of what to do with their money - what could be wrong with that? After the budget the UK press were full of stories of new pensioners trying to cancel their annuity contracts.
So if I suggest that those who are due to receive a defined contribution pension in the next few years and who want to invest their money prudently are likely to be worse off as a result of this budget, that might come as a bit of a surprise. The reason is because of three things economists (who are not automatically neoliberal) worry about: adverse selection, moral hazard and myopia. I will translate these in turn, in ascending order of importance. But before I do a very simple point. Annuities are a good idea, because they insure against uncertain lifetimes. So unless you know your date of death with be earlier than for your age group, you should invest a large part of your pension in some form of annuity.
Moral hazard. Pensioners can now take the risk that they will not live for long and blow their pension on expensive holidays, knowing that if they are wrong and live longer they can always fall back on the welfare state. A reasonable state pension should avoid this (because those receiving it do not qualify for welfare payments), but the IFS believe (pdf) this will only be partially true in the UK.
Myopia. As Tony Yates points out “there is abundant evidence from the experimental and other empirical literature in behavioural economics and finance that we are i) terrible at paying proper attention to the wants of our future selves [usually neglecting them] and ii) terrible at responding rationally to risk.” We know (IFS again) that people underestimate the life expectancy of their age group.
Adverse selection. If everyone has to take out an annuity, annuity providers can make a reasonable guess at how long people on average will live. If instead people can choose, annuity providers face an additional uncertainty: are those not choosing to take out an annuity doing so because they believe they will not live as long as the average for their age group? If that is true - which it almost certainly is - then annuity rates will fall, because those still taking out annuities will live on average for longer. A greater concern is that this additional uncertainty will reduce annuity rates still further, as annuity providers require an additional margin to compensate them for the extra risk they face. In theory, the market could collapse completely.
I do not mean to imply that any of these, or even all three combined, are sufficient to justify compulsory annuitisation. What they do show is that the naive ‘choice must be good’ line may be neoliberal, but it is not economics. What does seem pretty clear is that the budget will lead to a reduction in annuity rates, so a perfectly reasonable headline after the budget would have been “Chancellor cuts incomes for new prudent pensioners”. If you do not remember that headline in your newspaper, perhaps you should change newspaper.
There is another neoliberal fantasy, and that is that private provision must be better than public provision. Yet pensions illustrate one area where this can be the opposite of the truth. Defined contribution pension schemes suffer from intergenerational risk. Suppose that those arguing real interest rates will stay low for a long time are right (secular stagnation). That means that the generation receiving their pension during this period will end up with a lower pension income that those that go before or after them. Indeed it is just this effect which has made annuities unpopular and which the government is playing to. People would like to insure against this kind of risk, but the problem in this case is that we need an insurer who in effect lives forever, so they can smooth out these good and bad times. There is just one economic actor that could do this, and that is the state. The state could do this in many ways, ranging from some form of unfunded government pension scheme to providing insurance to annuity providers.
As Tony Yates notes, you can see additional government borrowing during severe (liquidity trap) recessions as just this kind of intergenerational risk sharing. He also points out that there are time inconsistency issues when the state performs this role, although I would add that if the old continue to vote more than the young these may not be critical. If Roger Farmer is right (pdf), these issues involving uncertainty over generations may have consequences far beyond pension provision, and again the state may have a key role to play. Unless, of course, you are a neoliberal who will not countenance such things.
This post was inspired by this from Tony Yates, and also drew heavily on this post-budget briefing by IFS economist Carl Emmerson. For a much more detailed analysis (based on the government’s earlier proposals but also of relevance now) see this study (pdf) by David Blake, Edmund Cannon and Ian Tonks.