Major public policy issues

In this section we look at four major public policy issues:

  • Access to affordable, quality housing
  • Income and pension security in an age of economic and financial insecurity
  • Funding long term care costs
  • Funding income in retirement and asset decumulation products

Access to affordable, quality housing

The housing market is one of the most dysfunctional markets we look at. It has a profoundly distorting effect on a range of policy issues including:

  • access to affordable and decent quality housing (owned and rented);
  • pressures on the public finances – the taxpayer is paying vast sums – £9.5 bn a year – to private landlords in the form of housing benefit[1];
  • household overindebtedness long term savings behaviours and financial resilience;
  • retirement provision;
  • transfers of wealth and intergenerational equity; and
  • contributes to systemic risk.

Worryingly, we do not seem to have learnt the lessons of the past. According to the OBR, the ratio of gross household debt to incomes is expected to rise to 167% by the end of 2017 and to 184% by the start of 2020 driven primarily by mortgage lending. This is much higher than the pre-crisis peak of 169%.

The financial services related priorities here are[2]:

  • preventing a new build-up of massive mortgage debt (and associated unsecured debt);
  • introducing a proper consumer protection regime for renters;
  • targeted rent controls; and
  • finding the most efficient way to fund an increase in the supply of affordable housing.

In addition to targeted rent controls, a proper consumer protection regime for renters would include: minimum standards on quality of housing; tenure rights; controls on letting agents; rights to redress for renters; and proper monitoring and enforcement.

Clearly, choosing the cheapest method of funding new homes is crucial to keeping housing costs affordable – in simple terms, higher costs results in higher rents. There are a number of mechanisms for funding housing on low cost terms including: government bonds (gilts); local authority funding mechanisms (by restarting the local authority bond market); or even by issuing National Savings and Investment Social Housing Bonds.

However, industry lobbyists are trying to create a role for institutional investors such as pension funds and insurers to provide funding for housebuilding. This would be a much more expensive way to fund housing. Institutional investors would demand a higher return and/ or some form of guarantee for cash flows. This means society would be paying more to borrow from pension funds while still taking on much of the future risks. Ultimately housing costs would be higher than necessary.

As with any major public policy issue, we need to have a frank informed debate on how to best fund the needed increase in affordable housing. If we make the wrong choices now, we could leave future generations with a unfair financial burden.

Income and pension security in an age of economic insecurity and uncertainty

We estimate that @ 40% of the workforce is in non-full time/ non-permanent work. In addition to low earnings, the uncertain and insecure nature of this work means that many of these households will find it hard to build up financial resilience and long term financial security. The self-employed are a particular concern.  18% of the self-employed participate in a pension scheme compared to 48% for employees. Pension participation rates have seen steep falls. In 1996/97, 62% of self-employed men were contributing to a pension compared to 21% in 2012/13. Self-employed women face particular problems – only 12% participate in a pension scheme compared to 21% of self-employed men. Only 10% of the self-employed in the 25-34 age group are in a pension scheme compared to 44% of employee counterparts; 22% of the 35-44 age group are in pension compared to 60% of employees.

Another key indicator of financial resilience and security is having insurance to fall back on in the event of a financial shock. The self-employed are significantly less likely to have key insurances such as mortgage protection and life insurance than employees in equivalent occupation categories.

The self-employed do not benefit from an employers’ sick pay schemes so they are particularly vulnerable to economic shocks. Nor do they benefit from statutory sick pay or maternity pay schemes[3]. The self-employed rely more on state support than full time employees. More than half of households with one or more full time self-employed people receive state support which makes them very vulnerable to benefits changes. The self-employed have the most to fear from the new reforms introducing the Universal Credit system – 37% are potentially adversely affected[4]. Moreover, research suggests that 40% of the self-employed do not claim Tax Credits to which they are entitled[5].

The self-employed take greater financial risks than those in permanent employment but the rewards for the self-employed are not higher (certainly in overall financial terms). State benefits can provide only a small amount of replacement income but very few have private sector income protection insurance as a substitute.

However, it is important to note that other vulnerable employees are affected by many of these problems, too.

The priorities now for the self-employed and others in vulnerable employment are to:

  • tackle the seriously low levels of pension underprovision; and
  • create a decent safety net to protect against economic shocks.

If we want to seriously address the pension underprovision of the most vulnerable groups the most obvious solution is for the state to step in and play the role of the employer by topping up pension contributions and make greater use of the existing NEST pension scheme. Alternatively, the state pension system could be reformed so it provides a low risk, cost effective option for the self-employed and others with low or uncertain incomes.

In the meantime, the Government should urgently address the flaws in the Universal Credit system highlighted above to ensure it does not adversely affect the self-employed and is better structured to meet the reality of self-employment. Moreover, a public information campaign is needed to raise awareness amongst the 40% of the self-employed do not claim Tax Credits.

Private sector income protection insurance is unlikely to an efficient way of providing a decent safety net for the self-employed and other vulnerable workers. A new state backed, collective scheme is likely to be more efficient and inclusive.

Funding long term care costs

Changing demographics in the UK – particularly the ageing population – raises difficult public policy challenges. The pension problems facing the UK have been well documented. But with 1 in 3 women and 1 in 4 men aged 65 now expected to need long term care, one of the other main challenges is how does society fund the costs of this care? It is important then that we find the fairest and most efficient way of meeting the combined costs of long term demographic related challenges.

With regards to long term care, the current government approach is based on capping the amount of local authority set care costs people would have to pay at £72,000. This is meant to provide some form of safety net to prevent people facing ‘catastrophic’ care costs. But recent research published by the Institute and Faculty of Actuaries (IFoA) estimates that just 8% of men and 15% of women entering care aged 85 today are likely to reach the new social care cap that is being introduced in 2016[6].

Moreover, it is important to note that this doesn’t cover daily living costs or top-up care costs. The cap only applies in relation to local authority set care costs. The IFoA found that, although the cap is set at £72,000, on average people are expected to spend around £140,000 on care costs before reaching it. If an individual is in long term care for 10 years, this cost can increase to around £250,000, even allowing for the cap. There are also significant regional variations in expected care costs and the time it is expected to take for the care cap to apply.

So, even with the cap, it is clear that we have not made that much progress on dealing with long term care costs – those in need of long term care may need to find significant additional funds to pay for their care.

Care costs can either be paid for on a pay-as-you-go basis (out of current taxes) or pre-funded in some way (prefunded hypothecated tax, through savings accumulated over time, some form of insurance or releasing equity from property).

In terms of financial vehicles, a number of possible options are available including:

  • through the state/local government (that is the state could require citizens to pay into what would be a hypothecated national insurance fund/ council tax);
  • other forms of collective provision (similar to the NEST pension scheme); or
  • individual private sector financial services products (long term care insurance, pension/ LTC hybrids, and private sector equity release schemes).

In setting the cap, the government had hoped that this would mean the insurance industry would be more willing to develop and offer new long term care insurance products. The theory is that people could insure themselves against that part of the costs which are predictable and insurers’ costs would be limited.

However, this does not strike us as a very efficient method of prefunding long term care costs. This arrangement would mean the state still taking on the ’catastrophic’ risk and picking up the bulk of the care costs. If the lessons of pension provision are anything to go by, private sector insurance products may not offer good value for consumers.

Moreover, despite urging by the government, even the insurance industry does not seem very keen to develop the sort of insurance products to cover care costs. For now, industry representatives appear to see no business case in the new long term care products and think it would be even harder to persuade consumers to take out insurance products than it has been to provide for a pension[7]. Of course, this could be just a bargaining tactic by the industry to try to extract an even more favourable environment for its products. We should not be surprised if the industry begins to lobby for a more favourable tax treatment of insurance contributions to incentivise consumers to take out insurance. But this would simply add to the costs of using private sector solutions.

This all highlights the difficulties involved in persuading the private sector and, of course, consumers to use private sector products. But if the private sector isn’t suitable, what are the alternatives?

Drawing on the lessons from pensions reform, which led to the establishment of the NEST pension scheme, relying on private insurance or extending the role of private sector pensions is unlikely to be effective and some form of collective provision (whether insurance based or prefunding) will be the most efficient way of protecting the maximum number of people from unforeseeable costs.

With local authorities cutting spending on long term care and the private sector so far unable to produce solutions to allow society to prefund care costs in an efficient way, it seems the long term care crisis can only get worse – specifically, the gap between the need for care and funds available (the funding gap) seems certain to grow[8]. At some stage, civil society will have to return to this issue and develop new policies to deal fund long term care costs in the most efficient, fairest and most equitable manner.

Funding income in retirement and asset decumulation products

The introduction of NEST and automatic enrolment represented real progress in terms of helping consumers build up pension assets and making the pensions industry work (although again there is still much to be done). However, until the recent announcement of the reforms to the annuities market, little attention has been paid so far to the other main part of the pensions equation – converting those funds built up over time into an income in retirement.

The conventional mechanism for creating an income in retirement has been to purchase an annuity. Annuities have many significant advantages for consumers. They can provide a ‘guaranteed’ and predictable income in retirement and the income is paid for the rest of the consumer’s life. This means that consumers do not have to take the risk of trying to guess how long s/ he is going to live for and spread available assets over that time – which if current demographic trends continue could be a significant length of time.

Conversely, the very features that are considered attractive in annuities have attracted criticism – such as lack of flexibility and choice, and there have been concerns about weak competition in the market.

We agree that the annuities market needed reforming. But this could have been done in a more measured way. Instead, the government announced major reforms which to all intents and purposes will completely liberalise the annuity system. These will take effect in April 2015 and as we explain elsewhere, we have serious concerns about the impact on retirement planning. While being promoted as offering greater freedom and choice to consumers, we think these reforms introduce even greater risks into the retirement planning process.

As explained, more work was already needed on decumulation options. But the annuity reforms mean that this work takes on a greater sense of urgency. Examining some of the major risks created by the reforms explains why.

First of all, there are major risks and costs involved in creating an alternative portfolio of retirement assets that would generate a similar level of cash flow produced by a more conventional annuity product. As the attached Age UK report shows (see Chart 3 in report), even for relatively small pots of money conventional annuities are producing an equivalent interest rate of 5.5% per annum[9]. We assume that an investor building an alternative portfolio would not want to invest everything in risky equity type products and would create a balanced portfolio including some ‘safer’ assets. However, as this chart shows, UK 20 yr Gilts are yielding around 2% while cash is yielding 0.5%[10]. Therefore, to generate an annuity like return (net, post charges), the investor (or fund manager) would have to achieve very high net returns on investments. This would require the investor to take on significant additional investment risk and volatility in retirement unless the investor has access to asset management products eg. structured products which claim to produce ‘guaranteed’ returns. But there are major concerns about the ability of these products to generate the claimed returns.

Moreover, there are a range of set-up and on-going charges to consider when creating and managing an alternative portfolio. These charges of course reduce the net return produced by the alternative portfolio which means that the investment part of the portfolio would have to produce an even higher return – creating yet more risks.

Of course, it may well be that a number of investors may be sophisticated and confident enough to construct and manage these alternative portfolios without requiring professional fund managers and advisers. But, to be frank, we think very few investors would have the capacity for doing so. Moreover, non-profit type financial guidance providers are unlikely to be able to provide these services.

An alternative solution would be to use income drawdown to release some cash and invest the rest in the alternative portfolio. But to prevent the investor running out of money, the residual portfolio would have to generate an even higher return than is required if the entire portfolio was kept
invested. This would expose that part of the portfolio to even greater risks.

Costs will also be a factor. These hybrid products would probably have two sets of costs. One set of costs relating to the management of the investment portfolio and a set of costs to manage the drawdown element. Taking into account the low real returns and high charges there is a risk that an investor with the typical pension fund amount could run out of money very quickly.

There would also be significant prudential risks if replacement products are sold on the same scale as annuities. Insurers are subject to reasonably tough prudential regulations. If asset managers manufacture large volumes of products claiming to offer guarantees they will also need to be subject to prudential regulation (not just client assets rules).

The core function of annuities is managing longevity risk. But, in addition to market risks, using an alternative portfolio also exposes investors to significant longevity risks. It is not possible to estimate with any degree of accuracy the life expectancy of an individual at the point of retirement (expect of course in the most tragic cases).

The annuities market has rightly attracted criticism for being inefficient and uncompetitive. But given the additional risks and costs involved, replacement solutions are likely to be as, if not more, inefficient. Indeed, the experience in Australia is that the ‘liberalisation’ of the pensions market and reduction in the availability of annuities means that the individual has to save an additional 15% to produce the same unit of income in retirement.

The impact on the remaining annuities market also has to be considered. Certain experts argue that consumers will still be able to choose annuities. But the removal of the longevity cross subsidy reduces the value of remaining annuities. So, the net effect will be to introduce greater risks and inefficiencies and damage the remaining annuities sector.

Moreover, there are significant concerns around disclosure and financial advice and guidance. As explained, if alternative products are to provide a similar income stream to annuities, the investment returns would need to be very high – or else invested in ‘guaranteed’ products. Using the UK example to illustrate, if we assume a portfolio consisting of 50% gilts/ 50% equities (even this is risky in retirement), the equity part of the portfolio would need to produce a return of around 8% per annum – and this is before charges.

Unless the investor was very sophisticated and experienced, s/he would need advice to understand the risks involved.  The rate of return is of course is much higher than the rates allowed by regulators to be used in sales and promotions. So there are real issues with regards to disclosure requirements.

Clearly, robust consumer protection and access to the right financial guidance and advice are short term priorities to protect consumers from the risks of misselling and from the wrong decisions. But, as well as presenting immediate risks, there are longer term concerns. The annuity reforms threaten to reverse the progress made through the introduction of NEST and autoenrolment. The reforms will also in our view introduce even greater inefficiencies into the pensions and retirement planning industry which will need to be monitored very closely by regulators.

To address these risks, one solution would be to introduce a NEST style decumulation option to act as a beacon of good value for consumers to help them make better decisions and promote some real competition in the market. Another potential solution would be to explore whether the state can play a bigger role in providing a low risk, good value alternative. Currently, people can ‘buy’ extra state pension through additional national insurance contributions or receive a higher state pension by deferring the point at which it is received. These options can offer good value for many people. But given the upheaval and new risks created by the annuity reforms, we think it is worth exploring whether these options can be improved – especially for households on low and/ or uncertain incomes.

However, there is another issue to consider – the role of property assets in generating a decent retirement income. It is difficult to get precise values but around 60% of the total £6.5 trillion wealth in the UK is in property – the over 65s have £1.1 trillion of unmortgaged equity. For many consumers, property is the single biggest asset they have and they may be expecting to rely on home equity to boost income or provide dignity and security in old age. Yet the home equity market has so far not produced good value, effective solutions.

A range of contributory factors mean that significant numbers of consumers do not have access to viable home equity products. Preliminary analysis has identified two main groups of consumers who are excluded from the market.

The first group refers to those consumers who commercially viable for the market but are denied access to products because existing market conditions restrict the ability of providers to meet their needs. The second group refers to consumers who excluded in the conventional sense because they do not have sufficient home equity to be commercially viable for the retail market – alternative business models and products are needed for this group.

Clearly, much more work is needed to assess the viability of using home equity to meet core financial needs particularly vulnerable households with comparatively small amounts of equity in their homes. New research and development is needed into innovative, affordable home equity plans for consumers with low amounts of home equity based on partnerships between third sector organisations and financial markets  – for example, housing associations, local authorities, and other quasi-market solutions problem with the lack of economies of scale.


[2] Clearly, there are issues around planning and making land available for housebuilding – but these are outside our scope

[3] although they could qualify for Employment and Support Allowance (ESA) and Maternity Allowance

[4] Why the self-employed need to wake up to the threat posed by Universal Credit, RSA, September 2014

[5] Boosting protection for the self-employed is a priority. But so too is raising awareness of existing entitlements, RSA, December 2014


[7] See, Insurers shun call to reduce burden of care cost in old age, Financial Times, p2, 20th January 2015

[8] Ceteris paribus – of course, advances in medical technology may improve matters but that is unpredictable