Some in the financial industry worry that as a result of the government's introduction of 'pension freedoms’, individuals will spend their retirement savings irresponsibly. There is little evidence to justify this concern.
So far, the UK’s defined contribution (DC) pension pots are too small and the ‘pension freedoms’ too young to draw conclusions on how individuals will spend their retirement money in the long run. For clues, however, we can look at other forms of savings and more mature DC markets such as Australia and the US. All this evidence suggests that most people are quite prudent and, if anything, underspend.
Individuals spend their financial wealth, but much slower than one might expect
A new report by the Institute for Fiscal Studies (IFS) looks at how individuals spend their financial wealth (which includes savings, current accounts and ISAs, but doesn’t include pensions).
The IFS estimates that pensioners currently draw down just 31% of net financial wealth between the ages of 70 and 90. Even retirees in the top half of the financial wealth distribution spend just 39% of their net financial wealth, on average.
The evidence from Australia is that pensioners are cautious rather than spendthrift in managing their retirement wealth. Wealthier retirees, on average, spend more in early retirement, but then tend to save in their less-active later years, whereas poorer pensioners tend to save from early on. Consequently, Australians on average pass on almost as much wealth as they had at the beginning of their retirement.
Smaller DC pots are often taken as cash. Unlike in the UK, however, the Australian state pension is means-tested. Taking the entire fund as a lump sum and paying off mortgage, for example, could make sense and result in a higher state pension.
A similar picture emerges from the US, where retirees tend to stay in broadly the same wealth brackets throughout retirement. Moreover, most of those who die with a low level of assets typically aren’t rich pensioners who spent all their money, but rather had similarly low levels at the start of their retirement. Pensioners with a higher level of education and no significant health issues, as well as couples with no changes to family structure, often see their assets increase.
It seems unlikely, therefore, that UK pensioners will rush to spend all their DC money once they get hold of it. As in Australia and the US, there is also anecdotal evidence that many who are used to saving throughout their lives continue to do so in retirement.
Recent academic work suggests that are essentially two reasons for saving/underspending in retirement – uncertainty about future risks (longevity and medical costs) and desire to leave inheritance. Similarly, the IFS research indicates that concerns about long-term care costs and plans to leave inheritance are associated with lower spending (although correlation doesn’t necessarily imply causation).
Focusing on customer needs and recognising different motives and concerns will be a start. There might be value in targeting those needs separately by, for example, providing different investments, tools or products for inheritance planning and spending in more active, earlier years (when many value flexibility and the ability to spend more) and also in later years (when simplicity and security are more important).
One could also advocate nudging towards annuities from 75 or 80, or using deferred annuities within a more holistic solution, as a simple way to provide piece of mind for retirees worried about running out of money. Finally, providing bite-size information and ‘just-in-time’ financial education could help with the complex decisions many people face.
How people feel about the prospects of risk and reward is important to 'journey planning' in DC schemes. But does an individual's natural aversion to losing money impact their retirement saving?