Taxation of Pensions Bill

Written evidence submitted by Hargreaves Lansdown (TP 11)

Summary

1. The changes being introduced via the Pensions Schemes Bill and the Taxation of Pensions Bill are welcome reforms however they come with significant risks. The pace with which they are being introduced means there is no proper overarching framework, nor is there sufficient time to address the myriad of unintended consequences.

2. We have set out below our principle concerns regarding the new freedoms.

· Pensions by default: a government policy mismatch

· Risks to investors

· The role of regulated advice

· The Guidance Guarantee

· Market competition

· Pension fraud

· Behavioural responses

· Hargreaves Lansdown proposals

3. In addition, we have made four suggestions more narrowly focussed on the Taxation of Pensions Bill itself.

· Make the temporary extension of the block transfer definition permanent.

· Only require an individual who has flexibly accessed pension benefits to inform the pension schemes of which they are an active member, rather than to inform all their pension schemes.

· Allow the open market to be used for inherited drawdown and make it compulsory for the original provider to offer this option.

· Allow drawdown payments for long term care to be tax-free.

Pensions by default: a government policy mis-match

4. Auto-enrolment has undoubtedly been a very positive policy measure. It has rightly enjoyed cross-party support. Auto-enrolment is based on inertia. Members are defaulted into pensions, given a default investment, a default contribution rate and can therefore be defaulted all the way through the savings journey. This works up to a point, however in the context of the budget reforms it now means millions of pension members may arrive in their 50s with no familiarity with managing investments (see below). They will be expected to make complex decisions regarding their pension pot and other assets. The Budget freedoms have moved engagement from being desirable to being an absolute necessity.

Risks to investors

5. Briefly, we see the following risks as most likely to cause investor detriment, we can explore these risks in more detail if required:

· Investment loss

· Longevity underestimation

· Longevity overestimation

· Market return sequencing

· Guarantee costs

· Lack of regulatory accountability

Investment loss

6. An unexpected fall in capital or income could cause serious hardship.

Longevity underestimation

7. Investors typically underestimate their life expectancy by several years. Even if they have an accurate assessment of average life expectancy for someone with their characteristics, many will still exceed that average.

Longevity overestimation

8. The converse is also potentially a problem; investors could lead an unnecessarily frugal retirement and die with too much money in the bank.

Market sequencing risk

9. This is a critical but poorly understood risk. If an investor starts drawing an income from a fund and suffers a few early years of poor returns, they will irreparably damage their savings. By contrast, if they are fortunate enough to enjoy an initial few years of good returns, they may then be set for life.

Guarantee costs

10. You can ‘insure’ a pension fund to protect it from investment losses. These can be expensive and sometimes unreliable. Typically it costs around an additional 1% a year, just for the guarantee; this is more than the total price cap for all the costs involved in running a workplace auto-enrolment pension scheme (set at 0.75%).

Lack of regulatory accountability

11. If it does go wrong (and for some people, it will) there are at present no clear lines of regulatory accountability. Where will the buck stop?

The role of regulated advice

12. Where investors receive regulated advice, it is reasonable to assume they will get a good outcome. Whilst some advice in the past has been less than perfect and there have been miss-selling scandals, because the advice is regulated, investors will at least have some redress if serious financial detriment can be proved to have been caused by their advice. This is not a perfect system and availability of advice is limited and can be expensive. Typically advice costs hundreds of pounds to deliver. Many investors reaching retirement are unlikely to receive regulated financial advice until more cost-effective propositions are developed.

13. Investors will therefore be dependent on their pension provider for the retirement income solutions with which they are presented.

14. Pension providers generally, including insurance companies and trust based occupational pension schemes, have a poor track record of serving their customers and members well at retirement. In spite of repeated calls to the government and the FCA for reform of the retirement process, for years the Open Market Option has failed to deliver good outcomes for investors. Take up rates have been stuck below 50%. This means the majority of retiring investors have been buying a ‘suboptimal’ retirement income. The scale of loss is substantial too, with the typical spread of annuity rates between the best and the worst in the market running at between 20% and 40%.

15. Given this experience, it would be naïve to expect anything to change with the introduction of the new freedoms next year. The new freedoms do not of themselves do anything to promote better shopping around on the part of scheme members, nor do they ensure members will be offered market competitive solutions at retirement.

The Guidance Guarantee

16. The Government has promised all investors will be offered free, impartial, face to face guidance. This is not going to solve the problem. The Guidance is analogous to a seatbelt in a car; it is undoubtedly going to make the vehicle occupant safer, but is not a complete solution to road safety. The wearing of the Guidance ‘seatbelt’ is optional, and even with the Guidance, you still need the financial equivalent of airbags, a driving test, crash-testing, a highway code and a highway patrol.

17. Many investors will not take up the Guidance although it is hard to predict exactly how many, as there are still many unknown factors. One study resulted in just a 2.5% take up, though this should not be interpreted as a definitive guide to what may happen next year: The nature of the pre-retirement communications, the publicity surrounding the Guidance, the ease of accessibility etc. will all make a difference. It is however safe to assume a significant proportion, quite possibly a majority, will not take up the Guidance. Even those who do receive the Guidance will still need to subsequently engage with commercial retirement income providers. This could be their existing pension provider, a drawdown provider or an annuity company.

18. When those investors do engage with retirement income solutions, there are at present very few safeguards to maximise the chances that the investor will get a good outcome. Pension providers’ past form (including Trust based schemes) indicate they will gravitate not to solutions which are best for their customers but to whatever is either simplest to administer or likely to generate the maximum profits.

19. An investor could simply contact their occupational pension scheme and ask for some money. From a regulatory point of view, all the scheme needs to do is send the money. Even if they are required to flag up the tax implications, there are no controls to ensure the investor is in a suitable investment fund, is drawing income at a sustainable rate, isn't cashing in investments which have just fallen in value, or indeed will get a nasty shock when one day the money runs out. Critically, there are no regulatory mechanisms in place to hold those pension providers to account. Similarly, if the investor decides they want to buy an annuity there is no requirement for their pension provider or scheme to provide a competitive and suitable annuity.

Market competition

20. Nothing in the new reforms will increase the likelihood of market competition working to the benefit of the investor or drive any kind of shopping around process. Arguably it will be even easier for a pension provider to sell to an existing customer a poorly priced or uncompetitive product. They will not be subject to any regulatory controls on the sales process, or any scrutiny regarding their product pricing. Worst of all will be where an investor draws an income from an investment fund in a trust based scheme. In this case there won't even be any product sale to regulate, so how can the regulator hope to supervise such transactions to ensure members are protected?

Pension Fraud

21. It will be much easier to defraud the unwary now you don’t even need to set up a spurious pension scheme. All the fraudsters need to do is to target investors over the age of 55 and persuade them to unlock their pensions. The fraudsters will do this by promising plausible but slightly over-inflated ‘guaranteed’ investment returns from ‘special’ schemes. Anyone foolish enough to be drawn into such schemes will cash in their pensions, incur a tax liability, hand their cash over to an unregulated scheme and never see the money again. The risk lies in the unregulated market, so it makes sense to create a more distinct brand around the regulated advisers and investment schemes. We have proposed a solution below.

Behavioural responses

22. It is difficult to anticipate what consumer responses will be to these changes. We know from client research that whilst the new freedoms are very popular, many investors still want a secure income in retirement. In a survey of over 1,000 investors, 94% said a secure income was quite or very important to them.

Hargreaves Lansdown proposals

Addressing market issues

23. Hargreaves Lansdown proposes that any organisation arranging a retirement income for a pension investor has to accept some responsibility for that arrangement. This means ensuring:

· it is market competitive,

· the investor is offered suitable choices, and

· risks are clearly explained and suitable for the target market.

For example, investors who have remained disengaged throughout the accumulation stage of their pension probably shouldn’t be defaulted into market-risk based arrangements for the decumulation phase.

24. If the pension provider is selecting an investment strategy and level of income on behalf of the investor, then it is imperative the investor is left in no doubt as to the level of risk they are facing, in terms of loss of capital and / or income and the extent to which they will be protected from such consequences.

25. If the investor is being protected through the use of hedging or derivative strategies to insure the fund or income against loss, then the investor needs to know the cost of that protection and the possible impact on investment returns (which can be considerable).

26. The formulation of a suitable regulatory structure to protect the vulnerable, to drive up standards and to promote market competition in the retirement income market is a complex challenge which needs to be completed in a very short time. A close watch needs to be kept on the development of this market, both in terms of the pensions industry’s answers to the challenges and also the FCA’s and The Pensions Regulator’s regulatory responses.

27. The risk of pension fraud means a clear distinction needs to be drawn between regulated and unregulated investments and advisers. There should be a clear Kitemark or logo which is only available for use by regulated businesses. It should also be an offence for any unregulated business to use this logo. This would then allow regulators, the media and the industry to promote a very clear message to investors: don’t do business with unregulated entities; if you do and you lose your money, you’ll have no come-back.

Making the temporary extension of the block transfer definition permanent

28. Some individuals have an historic right to take pension benefits before normal minimum pension age and/or a right to greater tax-free cash then the standard 25%. If these individuals wish to retain this protection there are restrictions on how they can transfer between pension schemes. The main restriction is that any transfer must involve at least one other member of their pension scheme.

29. When the pension freedoms were announced it was recognised that the only way these individuals would realistically be able to use these freedoms were if the new options were offered within their existing pension scheme. The Finance Act 2014 therefore temporarily extended the definition of a block transfer to allow these individuals to transfer without another member and still retain this protection.

30. Once this temporary extension expires many individuals who do not want to lose this protection will again be effectively trapped in their existing pension scheme and unable to use the pension freedoms. We therefore suggest that this temporary extension is made permanent by omitting sub-paragraphs (b) and (c) from Finance Act 2004, Schedule 36 paragraph 22(6A).

Information requirements for individuals who have flexibly accessed pension

31. Paragraph 87 of the schedule adds to the existing information requirements. [1] This requires an individual to inform all pension schemes of which they are a member when they have first flexibly accessed pension benefits [2] or the first time a drawdown pension fund becomes a flexi-access drawdown pension fund. [3]

32. Given that the average individual could have eleven [4] pension schemes in their lifetime and the estimated £400 million of unclaimed money which is in pension and life assurance schemes [5] this is a disproportionate requirement which is unlikely to be fully met. We therefore suggest new regulations 14ZB and 14ZE are amended so the information requirement will only apply to schemes of which the individual is an active member or to which they pay a relevant contribution. This could be achieved by using similar wording to that used in paragraph (1) of new regulation 14ZD.

Inherited drawdown – using the open market

33. Current legislation [6] only allows for dependant’s drawdown if it is offered by the pension scheme of the deceased member. The proposed amendment to the Taxation of Bill [7] also specifies that dependants, nominee or successor income drawdown will only be available when designated under the pension scheme of the deceased member.

34. Within the Treasury document published on 1 October 2014 it states, in relation to beneficiary’s drawdown, that The Government is aware that in some cases, a pension provider may choose not to offer drawdown. In addition, the National Association of Pension Funds’ written evidence submitted to the Pension Schemes Bill committee states that schemes and their service providers cannot make expensive system changes without the certainty of Royal Assent and made regulations. It seems clear that for many individuals, beneficiary’s drawdown will not be available from 6 April 2015.

35. We therefore suggest that where a pension scheme is not yet ready to offer beneficiary’s income drawdown they should be required to offer an option whereby the fund is designated as available for beneficiary’s income drawdown immediately before being transferred to a pension scheme which is able to offer full beneficiary’s income drawdown.

Drawdown payments for long term care to be tax-free

36. In April 2015 both part one of the Care Act 2014 and the Taxation of Pensions Bill are due to be implemented. This provides the opportunity for joined-up legislation covering both pensions and long term care. In particular, this allows pension funds to be used to fund long term care.

37. The reasoning behind incentivising retirement saving also applies to incentivising long term care saving. This could be achieved by a specialist savings vehicle providing incentives to contribute, restrictions on early withdrawal and incentives not to withdraw savings. This would however take time and money to set up even before any individual started to build up any savings.

38. A pension already provides for tax relief on contributions, is broadly free of tax while invested and has a minimum age at which pension investments can be withdrawn. The provision in this Bill to allow pension assets to be passed down free of tax on death before 75 will also remove an incentive to remove money from pensions between minimum pension age and 75.

39. The one shortfall preventing a pension from being a vehicle which would be used to fund long term care is the lack of an incentive to retain monies within a pension after 75. To rectify this shortfall it should be made more cost effective to fund long term care from within a pension than from outside a pension.

40. We therefore suggest that payments from a pension to a registered long term care provider for the benefit of the individual or their spouse/partner should be free of income tax. This would mirror the way in which a non-pension immediate care annuity can be used to pay for long term care.

November 2014

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