PENSIONSANDSAVINGS.COM

1 June 2014

• Government is right to legislate to permit Collective Defined Contribution pensions but beware over-optimistic claims
• In theory, they are better for employers than traditional final salary and better for workers than traditional defined contribution
• In practice, they still suffer from market and actuarial risks and new pension freedoms may mean they are less attractive for members
• Lower earners may subsidise higher earners -Younger members may subsidise older members

The Government is set to unveil another Pensions Bill in this week’s Queen’s Speech.  This Bill will be the third major piece of pensions legislation launched by the Coalition.  Today’s headlines claim that one of the centrepieces of the Bill will be introduction of new-style pensions that will have the potential to increase member’s pension income by 30% or so. 

It is claimed that by allowing employers to contribute to so-called ‘Collective Defined Contribution’ (CDC) schemes, members will achieve much better outcomes, without imposing unacceptable risks on employers.  These new schemes are commonplace in other countries, such as the Netherlands, while Canada and Scandinavia are also increasingly looking at these plans.  It is important, however, to recognise that there are both advantages and disadvantages to these types of pension scheme.

Summary:

Possible advantages of CDC:

• Employers pay fixed levels of contributions (typically being 10-12% of salary)
• No balance sheet risk for employers
• Members are offered a ‘target’ level of pension, related to average salary
• Members are offered the chance of inflation protection to their pensions
• Less risk for employers than DB and less risk for members than pure DC
• Pooling investments allows lower management costs and higher pension fund
• Pooling investments in large funds offers chance for better spread of assets to deliver higher returns – current DC pensions usually just equities and fixed income, whereas CDC could include many other assets such as infrastructure, forestry etc.
• Government estimates CDC pensions could be up to 30% higher than pure DC.

Possible Disadvantages of CDC

• Pensions in payment could fall
• Pensions are at the mercy of market forecasts – and actuarial accuracy
• If pensions are too generous due to forecast errors, they will have to be cut
• Younger members may end up with lower pensions than older members
• On average, lower earners live less long than high earners, so low earners may subsidise the pensions of the high earners in the scheme
• Relies on trust between generations and requires ongoing pool of new members coming in and contributing through time
• Sounds rather like previous with-profits investment approaches which did not always work out well due to unexpected market movements.

On balance

• Government is right to legislate to permit CDC but it should not over-hype the benefits
• The new Budget pension freedoms may mean people prefer pure DC that they can access in retirement if they wish to, as CDC usually means they cannot just take cash.

So how does CDC work?  The theory is that an employer will contribute a fixed level of contributions (the ‘Defined Contribution’ or ‘DC’ part), with members also paying contributions at a specified level.  These contributions will go into a giant pool of assets (the ‘Collective’ part of ‘CDC’) where a fund is built up over time and pays out pensions when members reach the scheme’s pension age.  So this is not like individual DC, where each member has their own fund and then buys a pension income (usually with an annuity) when they reach pension age.  The pension assets build up in a collective pool and those assets pay the pensions each year.  This saves paying profit margins to insurers when buying annuities which should generate higher pensions and it also saves significant sums on managing the assets, because of economies of scale, again enabling higher pensions because less money is taken out in fees.

Usually promises a pension related to average salary plus inflation protection – but this is only an aspiration not a guarantee:  The pensions paid will be determined usually as a proportion of career average salary, with an actuarial calculation determining how much can be afforded.  The aim will usually be to pay pensioners a proportion of their average salary during their career, and also to increase that pension over time in line with inflation.  However, the inflation linking may or may not be paid, depending on how the assets in the scheme perform and, indeed, the level of pension itself could also be reduced over time if scheme assets perform much worse than expected.

‘Target Pension’ not guaranteed:  These schemes are sometimes called ‘Target Pension Plans’ since members are told to expect a pension which is a proportion of their average salary and also some inflation uplift over time.  However this is the ‘target pension’ and may not actually be delivered if investment or actuarial assumptions are not achieved.  These plans are a form of ‘adjustable Defined Benefit’ schemes.  The benefit is defined for members, but may not actually be delivered.

Government plans to legalise such schemes, currently benefits cannot be reduced: Such schemes are illegal at the moment and the Queen’s Speech will introduce plans to legislate for these kinds of pension arrangements to be permitted by law.  Currently, if an employer promises a ‘Defined Benefit’ pension, specifying a particular pension level, or starts paying a pension out to pensioners, the law says these benefits can never be reduced under any circumstances.  That means employers take on an open-ended commitment which has proved too risky for them to underwrite in recent years – as markets have performed less strongly than expected and life expectancy has continued to rise.  By allowing CDC schemes, the Government is offering employers a less onerous system of promising pensions to their staff.  The employer will no longer have to carry balance sheet risk from the pension plan, because the contributions are defined and the benefits can be adjusted if necessary.  The Government hopes that employers who might otherwise simply close their current Defined Benefit scheme and move to pure Defined Contribution, will instead be persuaded to introduce CDC schemes, which are potentially better for members and less risky for members than pure DC.

All this sounds good in theory.  What are the downsides?

Pensions in payment might have to be cut:  There are, unfortunately, some serious concerns about CDC.  Firstly, it is clear that pensions could fall if markets do poorly.  This has already happened in the Netherlands.  For example, some CDC members have had no inflation increases on their pensions for nearly 10 years and then had their pensions cut by about 5% in the past couple of years.  Members need to understand that there are no ‘guarantees’ on their pensions in these schemes.

Relies on trust, inter-generational risk-sharing and reliability of actuarial forecasts:  Second, CDC relies on trust and willingness to share risks between generations.   As the scheme pays out the pension, the ultimate payments are determined by actuaries who make forecasts of future returns and life expectancy of members.  If those forecasts are wrong, the solvency of the scheme could be jeopardised and benefit cuts would be inevitable.  However, there are risks that actuaries will not recognise the need to reduce benefits in time and continue to pay out more than is justified because they fail to foresee the future problems.  In such cases, the older members will have had a more than fair share of the scheme assets, leaving younger members with less pensions than their own contributions would have generated.

Low earners may subsidise higher earners:  Another issue is that CDC could see lower earners subsidising pensions for higher earners, because low earners typically have lower life expectancy than the better off.  For similar percentages of salary, the assets in the CDC scheme may end up being used more than proportionately to pay pensions to the higher income members who live longer than their lower earning colleagues.

Budget changes would allow people to cash-in pensions if they need to but CDC usually would not:  Finally, it is not clear that CDC is in every members’ interests following the introduction of the other measures unveiled in the Queen’s Speech.  As DC members will in future have freedom to take their pensions as cash if they wish, and nobody will be effectively forced to buy an annuity or secure an income any more, workers may prefer to be in control of their own pension outcomes, rather than relying on being part of a collective scheme that promises them a target level of pension which may or may not materialise.  It is unlikely that CDC schemes would allow members to transfer their benefits out as cash, because the ongoing success of CDC relies on a constant inflow of new members’ contributions to build up the fund.

Government right to legislate to allow CDC – lower management fees, better investment approaches can mean higher pension:  Overall, it is absolutely right that the Government should legislate to permit CDC schemes and to end the draconian restrictions that employers currently face in UK Defined Benefit pension provision.  However, it is important not to over-hype the potential benefits of such pension arrangements.  They can, indeed, offer better pension outcomes than pure DC and also are much more likely to be acceptable to employers than traditional DB, however with the new pension freedoms introduced in the recent Budget, many people may prefer to have their own pension arrangement.  The challenge, then, is to ensure pension providers can offer individuals a much more cost-effective investment solution to accumulating their own pension fund than has hitherto been the case.  Being part of large collective asset pools with lower management fees and a broader spread of investments, should generate larger pension funds.  One of the biggest drawbacks of the current DC schemes is the high costs of management and administration and the poor range of investments offered.  The industry should come up with more diversified investment options at lower cost to deliver better value over time. 

Mastertrusts such as NEST could deliver more effective pooled funds for pure DC too:  I hope that perhaps Mastertrusts such as NEST can come up with such solutions or other pension companies might enter the market to offer these options.  With auto-enrolment bringing millions more workers and billions more assets into pensions, there is a tremendous opportunity to revolutionise pension delivery in the UK.