To get better pensions we need to share risk

Yesterday, Steve Webb announced he was  to review the level of protection that needed to be provided to private pensions in payment. His  intention is to help the solvency of defined benefit schemes which might need to reserve less for future guarantees. He is advocating that more risk be born by members if they are to continue to benefit from certain outcomes and this will mean less protection of guaranteed increases to some pensions as they get paid.

Any suggestion that member protection be reduced causes concern among those whose job it is to protect member interests-trustees. However, as this brilliant discussion document from my friend and colleague Derek Benstead demonstrates, the consequences of over-regulated member protection are often unintended. Over regulation leading to too much member protection (here in the protection of guaranteed increases in retirement) can kill the golden goose leaving a ” perfect stadium with no one watching the game”.

Many trustees, union officials among them, understand this and recognise that just as DB can best be supported by easing the burden or retirement guarantees, so DC outcomes can best be improved by allowing DC to share in a managed drawdown from a collective fund – as DB pensions would become if the new Government thinking was adopted.

Derek’s comments are a critique of an argument put forward in 2009 by the then Government Actuary that what we today know as “collective DC” was prone to the same flaws as the recently discredited “with-profit annuity”. Derek comes at pensions from a very different angle than we are used to.  He genuinely understands the principle behind mutuality and he believes we can, as the Dutch have, employ to a system of not for profit pension provision based on a society that sorts its problems out for itself. Though his thinking is contrarian, it is expressed with such clarity, integrity  and vigour that I find it utterly compelling.

I include his arguments unexpurgated and without further comment –  for your edification and enjoyment.

 A discussion document on CDC

Equating non-commercial CDC schemes to commercial with profit funds is misguided. As a former Standard Life endowment policy holder I know how my maturity payment was much reduced by Standard Life’s overspend on maturities before mine. With profit payout overspends are decided by a board of directors most of whom are not actuaries and who are motivated by payout league tables and sales drives. But a CDC fund run by trustees on behalf of an employer who simply wants his staff to have pensions does not have such commercial pressures. Trustees seeking to fulfil their normal duty to be fair to all members should alert to intergenerational issues and the risk of overspending.

I have found the attached DWP summary paper of GAD’s CDC work. I can’t find a full GAD paper on the internet and I changed jobs in late 2009, so if I had a GAD paper it is likely I left it behind at my last job. However, there is some interesting material in the DWP’s summary paper.

First, the description of a CDC scheme on page 5 is on the whole a good definition. But in the rest of the paper it is clear that GAD’s modelling is of much narrower scope than the broad definition on page 5.  Several things suggest to me that GAD’s modelling was misguided.

One, on page 17, there is a sentence which says “An absence of new members coupled with poor investment returns can lead to a scheme failing, with some members (both active and deferred) being left with no assets at all.”  There is something very wrong with GAD’s modelling if the money is running out even while there are some non-pensioners left.  I could perhaps understand it if the money ran out because the last handful of pensioners lived unexpectedly long, but in practice I would expect a running down CDC scheme to fully annuitise sometime after there ceased to be any non-pensioners.  The modelled decision making must be very wrong.  The correct conclusion must surely be, not that CDC doesn’t work, but that GAD’s modelling doesn’t work.

On page 6, one of the listed characteristics of the model is “Both pensions and pension increases are reserved for on an estimated buyout basis”.  On page 7, another is “The CDC scheme is invested 100% in equities”.

Why is GAD reserving for CDC pensions on a buy out basis? The pensions in a CDC scheme should not be guaranteed so there should be nothing to reserve for on a buy out basis.  Second, the modelled scheme is invested in equities.  Buy out pricing, which is driven by bond yields (or swaps), tells us nothing about the income to be expected on the equities.  Managing pension awards in an equity invested CDC scheme by reference to the bond market is a nonsense: the state of the bond markets tells us nothing about the pension payments that can be afforded from equity income.  So while the DWP report is not detailed about the modelling GAD did, it is clear that it has not been done well.

An equity invested CDC scheme should be managed by estimating the expected future dividend income and future contributions, and balancing expected pension payments for past and future service to that.  Clearly whatever the GAD modelling was, they didn’t equate the expected income and outgo, and for that reason in some scenarios they ran out of money.

To construct an up to date example, suppose a CDC scheme has a pension increase policy before and after retirement of RPI + 1% per annum, say, and is wholly invested in UK equities.  It would have seen its dividend income fall by 27.5% in real terms over the period July 2008 to June 2010. That doesn’t mean the pension has to go down 27.5% overnight. A new increase policy of say RPI – 0.5% pa would be more than sufficient to adjust benefit payouts over the life of the scheme to match the reduced dividend income (if the average duration of liabilities is 20 years, then a 1.5% reduction in annual increases is a 30% saving). The unprecedentedly severe reduction in dividends we have seen recently is easily handled in a CDC scheme.

No doubt it will be very difficult to wean the DWP off their misguided ideas about member protection. I don’t find the “regulatory own funds” regime very helpful and CDC is a wider idea than RoF.  Yet the DWP seems to have reached a position in which they think CDC = RoF.

Something close to CDC could be achieved in the DB arena if only the DWP would remove statutory minimum pension increases in payment.  We could then have a DB career average scheme with entirely discretionary pre-retirement revaluation and post retirement increases.  A DB pension cannot be decreased so there is a benefit guarantee to be met and this design is not CDC.  However, even the recent economic difficulties need not come close to triggering a need to reduce a pension in this model, as my example shows. The only step needed to turn such a scheme into CDC is to permit pensions to go down if needs be.  

Considering member protection, the important point is that CDC is better than money purchase DC, not that it is worse than DB.  Of course CDC is worse for member protection than DB, CDC is DC after all.  The point to focus on is that the defined contributions paid into a trust will be spent on the members.  The promise is the contribution, not the benefit.  Whatever the benefit outcome is, for better or worse, it will be worth what was paid in, and the DWP agrees that the benefit outcomes in CDC will on average be bigger and less variable than in money purchase DC.

The DWP needs to realise that DB member protections only protect members if they are in DB schemes.  The ONS occupational pensions survey shows that the number of active members in private DB schemes open to new entrants is about 1.0m, down from nearer 6m in the mid 1990s.  Member protection is not a function of regulation alone. It is the product of regulation and employers’ willingness to provide DB schemes.  We are surely at a point that employers’ declining willingness to sponsor DB schemes has more than offset the effect of “member protecting” regulations, and increasing regulation now has the effect of reducing the number of open schemes and reducing the number of protected members.  I suggest we’re in the position where the arrow is on the graphical illustration below.


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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