Optional Annuities Could Mean Working Pensions

Odd that Will Hutton should claim in The Observer, of all places, that making the purchase of pension annuities optional will end in long term social disaster. UK pensions are already a long term social disaster. Hutton himself points out that "400,000 people buy £11bn of annuities every year", yet "the annuity market [has become] overstretched, offering indifferent and often wildly different rates." 

This is because consumers have no choice. There's no competitive pressure at all on the insurance companies or their agents to remove unnecessary middlemen, reduce fees to customers or simplify products. In fact, the Financial Services Consumer Panel recently found that the annuities industry continued to focus on increasing its revenues through product complexity, even when consumers were given the option to shop around. No one in the industry seized the opportunity to make annuities more transparent and better value for the consumer. [Update on 26 March: Legal & General has suggested the market for individual annuities will shrink by 75% - rather endorsing the government decision to make them optional!].

Will Hutton argues that rather than make annuities optional "the response should have been to redesign [the market] and figure out ways it could have offered better rates with smarter investment vehicles". But that seems naive, given the FSCP findings. The industry had that opportunity and declined it. 

It's equally naive to suggest that less demand for annuities will mean losing a valuable opportunity for insurance companies to 'pool the risk' of funding pensions. The industry merely sees risk pooling as a chance to exploit asymmetries of information to line its own pockets. 

The only way for the government to shake up the cosy annuities cartel was to remove the implicit guarantee that everyone would have to buy an annuity. 

Mr Hutton then seeks to set up some kind of moral panic that the 'freedom to buy a Lamborghini' instead of an annuity will result in people simply frittering away their life savings. Not only does this suggest that he'd rather your life savings were placed in the grubby mitts of the annuities industry so they can buy the Lamborghinis, but it also insults the consumers who face the abyss of the annuities market. Their concern clearly arises from the lack of decent returns, not because they're eager to spend the cash on exotic cars.

Finally, Will suggests that the State is entitled to control how you invest your pension money because it allowed you to avoid paying income tax on your pension contributions in the first place. If you agree with that, then presumably you would say the State is entitled to control how you spend every penny of your income that it has allowed you to keep. This of course places a great deal of trust in the State's financial management capabilities that we know from bitter experience is ill-deserved. As a result, it's more likely that citizens will gain greater control over the allocation of 'their' tax contributions, not less (as I've joked about previously). But regardless of whether it's the State or the taxpayer who is in control, neither party wants the State to be saddled with the consequences of an uncompetitive and opaque annuities market. That would only suit the annuities spivs. Again, the only alternative is to expose the market to competition from all manner of transparent savings and investment opportunities. 

Importantly for economic growth, the freedom to avoid annuities opens up the potential for £11bn a year to be invested directly into the productive economy at better returns in much the same way that the new ISA rules will liberate 'dead money' from low yield bank deposits. Not only could we see some pension capital crowd-invested into long term business and infrastructure projects in a way that won't be interrupted by the need to purchase an annuity, but those in draw-down might also consider some 3 to 5 year loans to creditworthy borrowers as a way to generate some additional monthly income.

Careful What You Incentivise

Two things seem to be choking the flow of money to people and small businesses in the UK: broken regulation and perverse incentives. Yet there's a tendency to focus more on regulation, and to only see the obvious incentives - like bankers bonuses. Some innovative self-regulation in retail finance has been welcomed by the UK government, and banking reform creeps ahead. But all this could prove futile if problems with incentives are not also addressed. To fix those, we need to look below the surface at the more fundamental incentives at play in the financial system. In particular, we need to understand the extent to which the likes of ISA schemes and pension investment rules are limiting competition and innovation in financial services and inhibiting economic growth. I've summarised some recent debate on this below, and added some comments on the government's latest defence of the ISA scheme. I'd welcome your thoughts.

Some of the perverse incentives have been outlined to government by tax colleagues previously (in Annex 3 to this document). In essence, the contention has been that certain tax relief selectively favours banks and the suppliers of regulated investments to the detriment of innovation and competition. In particular, the tax free ISA system funnels ordinary people's savings into UK bank deposits on a vast scale, which the banks then fail to lend. This effectively discourages and inhibits those same people from diversifying, one alternative being to extend finance directly to other creditworthy people and businesses through peer-to-peer platforms. As a result, it's been suggested that the ISA system should be extended to cover such direct finance. Indeed, in his response to the Red Tape Challenge, Mark Littlewood, Director-General of the Institute of Economic Affairs and a 'Sector Champion' said:

"...it is surely worth noting that the present format and definition of the ISA wrap may have raised “barrier to entry” problems for new financial products and it may be beneficial to review these to stimulate innovation in the sector."

But the impact on innovation is merely the tip of the iceberg. It's the impact on the wider economy that must be understood.

There is overwhelming evidence that the UK's small businesses are cash-starved. They represent 99.9% of all UK enterprises and are responsible for 60% of private sector employment. Their output is critical to the UK's economic growth, which has stalled. Yet they face a funding gap of £26bn - £52bn over the next 5 years. Critically, the four banks which control 90% of the small business finance market are lending less and less to them. This is a red flag. You might think from their enormous market share that these banks would consider small business lending to be very important and a retreat from that market unwise. But, as the economist Richard Werner has pointed out, the reality is that only about 10% of the overall credit issued by our banks goes to productive firms. The other 90% goes to fund deals involving financial assets which don't count towards economic growth figures. So for these banks small business lending is actually a sideshow. They clearly make their money elsewhere.

Yet the ISA scheme had lured savings and investments of £391bn from UK adults by the April 2012, half of which is in cash deposits in these same banks. And they pay nothing for it - a paltry 0.41% in interest after 'teaser rates' expire, according to a 'super complaint' by Consumer Focus in 2010. 

In other words, the government appears to be incentivising workers to plough their savings into banks which virtually ignore the sector on which most of those same workers depend for their income. 

Contrast this with the position in Germany, where 70% of the banking sector comprises hundreds of small, locally-controlled banks who provide 40% of all loans to SMEs.  In an ironic twist, the UK government now sees peer-to-peer platforms as a similar conduit for a new German-style government-directed lending programme. But it appears never to have openly considered that the limited scope of the ISA scheme is part of the problem. 

In March, the goverment defended the narrow scope of the ISA scheme for the reasons extracted here. In September, the government gave a different response (see p. 13 here). In the hope of sparking wider debate on the issues, I've set out the current defence of the status quo below (my additions/comments in square brackets). I welcome any comments.

"HM Treasury believes that there is not a strong enough case for [making bad debt relief available to P2P lenders], as creating an exception would add complexity to the tax system and is difficult to justify when other [unspecified] forms of investment do not qualify for bad debt relief. Moreover, the current tax treatment of P2P investors is not necessarily a barrier to further expansion, as witnessed by the impressive growth in the industry in recent years.

...HM Treasury does not believe that P2P loans are suitable for inclusion in ISAs. The risk profile of P2P lending is too high [compared to what? cash ISAs? stocks and shares ISAs?], and it is unlikely that the platform can satisfy some of the [unspecified] features essential to the operation of ISAs.

Consumers tend to view ISAs as a relatively safe and simple investment vehicle [this fails to distinguish between cash ISAs and stocks/shares ISAs. And are they safe?]. ISA investments are thought of as relatively low-risk, and consumers should be able to get access to their funds whenever they wish. This is less likely to be the case with P2P lending than with existing ISA Qualifying Investments [this could be cured by permitting secondary markets in P2P loans]. 

Similarly, existing Regulations require ISAs to be operated through an ISA Manager [regulations could include P2P platforms], who invests through persons or firms who are authorised by the FSA, and thus have access to the FSCS [this does not mean you can't lose the principal in your stocks/shares ISAs, or stop banks paying 0.41% interest on cash ISAs]. As far as we are aware, current P2P lending platforms are not conducive to the ISA Manager role, are not regulated by the FSA, and do not offer Financial Services Compensation Scheme (FSCS) protection [any or all of which could be changed by regulation].

Finally, in order to be included in an ISA, P2P loans will require to be listed as a Qualifying Investment. Qualifying Investments are identified generically. It would be extremely difficult to restrict a generic description such as “loan” only to loans made via P2P lending platforms [but none of the qualifying investments are so generic, being limited by reference to 'banks', 'building societies', 'recognised stock exchanges' etc., so why not by reference to 'P2P platforms'?]. Exclusion from the ISA wrapper does not make this type of lending exceptional; rather, it puts it on the same footing as investment in stocks and shares issued by unlisted companies [how are these activities equivalent?]."