Collective Defined Contribution Schemes – A Shameful Missed Opportunity | AgeWage: Making your money work as hard as you do

An article by Kevin Wesbroom.

In December 2008 the Government published the response to its paper on risk sharing pension schemes. The opening sentence of the Executive Summary states “The Government is committed to encouraging good practice pension provision.” In December 2009 the Government published their assessment of Collective Defined Contribution (CDC) schemes and concluded “the Government should take no further action on CDC schemes”.

So, was CDC just a nice idea that had no legs – or did the Government simply wimp out and pathetically fail to follow through on its earlier promise (you may get a hint as to how the author feels).

Let’s look at the Government’s own findings. In case you may not understand what a CDC scheme is, it has a magical quality. To the member it looks like a DB scheme with a pension (not guaranteed) from a given pension age. But for the employer is it wonderful – it is a pure DC scheme so no nasty comebacks, no accounting surpluses, no surpluses or more worryingly no balance sheet deficits. Risk is hared between members, mainly through variable rate of indexation of pensions earned. For sure there are issues to be addressed, and the Government (DWP) analysis took place under six headings.

1. Level of returns for members

The Government commissioned the Government Actuaries Department (GAD) to do some modelling and they found:

“CDC schemes do appear to exhibit superior performance on average when compared to conventional DC schemes. In theory this improvement is in the order of 20 to 25 per cent, but in the simulation it is as high as 39 per cent for some members.”

Say that again?! Benefits a third bigger than conventional DC Schemes?? That sounds like a prize worth going for!

2. Predictability of income in retirement

We know that the outcome of DC Schemes can be volatile – is CDC any better?

“The GAD results show that in a CDC scheme an individual’s starting pension is less dependent on the particular scenario experienced, i.e. is less dependent on whether the individual happens to retire in a downturn or in a boom.”

Or as the GAD put it:

“Relative to DC there is more predictability in an individual’s starting pension”

Interesting – so the pension is bigger and more stable. Surely it must be worth looking at this further?

3. Intergenerational transfers

One of the key aspects of CDC schemes is that they do involve risk sharing – not sharing between the member and the company but between different members of the schemes. There is a smoothing of outcomes which results in transfers between different groups of participants. The DWP point out one potential pitfall:

“Cross-subsidies arising from the smoothing mechanism are inherent in the modelled CDC scheme. They have considerable implications for intergenerational equity.”

Dealing with these issues of smoothing requires very careful communication to members and good actuarial control processes. Dealing with these long term issues is a core part of actuarial training – but we need to be honest and accept that actuarial credibility may not be all that high, in the light of Equitable Life and other fiascos. So we had proposed a publicly accessible website with full information on each CDC scheme, updated on a regular e.g. quarterly basis. Technology makes this perfectly feasible. We don’t expect members of the public to flock to this website – but we do expect other actuaries to do so, and so ensure that no scheme goes out too far on a limb.

The GAD noted one way to address some of these concerns:

“the use of additional prudence in the actuarial basis used to allocate target pensions would change the balance of these cross-subsidies.”

4. Stability of CDC schemes

The DWP flag up a concern as to whether CDC schemes work on a long-term basis:

“the results do suggest that CDC schemes appear to require a continuing stream of member contributions to ensure 100% sustainability over time and to allow risk sharing to operate between members..”

The GAD point out that

“It would be very difficult to contain risk levels for schemes that had very small numbers of new entrants. When there are few or no new members there is a higher probability of a scheme failing and leaving some members without any pension or facing significant cuts being made to younger members’ pensions.”

We agree that this issue needs to be addressed. The Dutch solution involves fewer but larger schemes than we typically have seen in the UK. These larger schemes would have a longer life than a single employer’s scheme. Even if an individual CDC scheme is closed, it could be absorbed into larger continuing CDC schemes. In an extreme event of no continued CDC arrangement, the initial plan would revert to a pure DC arrangement at the point of termination. So yes there is an issue here, but not an insoluble one.

5. Legal implications of CDC schemes

Now we get to the interesting part – can the Europeans find a way to scupper CDC plans? The DWP ask questions such as:

“We considered whether CDC schemes could fit into the definition of money purchase schemes and thus be compliant with European legislation in a similar way to DC schemes where assets always meet liabilities.”

They point out some difficulties:

“A complexity with this lies in the practicality of assessing the financial commitments of a scheme which could reduce its liabilities if assets fall in value. It is not clear how the extent of such liabilities could be assessed and how to determine funding requirements.”

The DWP conclude this is all too hard. They do accept that another EU country – Holland – has found ways to make CDC schemes work, but seem to conclude they are fundamentally different to what we would want to offer in the UK. Even if we park the question as to whether the DWP analysis is correct – based on informed Counsel’s opinion? – is it right to simply wave the white flag because I looks a little complicated? Talk to me again about being “committed to encouraging good pensions”?

6. Potential demand for CDC schemes

The DWP carried out a small scale survey amongst employers.

“In the small-scale qualitative research investigating employer attitudes to CDC schemes, it transpired that employers were sceptical of the potential for higher returns (due to administration costs and scepticism about the performance of financial markets) and of the greater predictability of CDC scheme pension outcomes (as pensions are not guaranteed).”

I suspect there is something here around the framing of this question. Suppose I were to ask employers the following question

“would you be interested in a type of pension that might give your employees one third more than at present, greater stability and predictability, but was guaranteed not to involve you in any DB liability?”

Why would anybody not be in favour? The DWP did note that enthusiasm was higher amongst existing DC schemes, rather than DB schemes:

“Employers with contract-based DC schemes who would like to deliver a better pension to their employees might consider CDC schemes, especially if CDC schemes became the expected norm in their industry.”

So given the DWP analysis of the issue, it would not have been surprising if they reached exactly the opposite conclusion to the one they have – why not support CDC schemes? So why are we throwing down this opportunity that just might mean that private sector employees could continue to participate in DB style pensions? Or is the Government really saying that it has abandoned the private sector to DC? What about if then turn the idea around – tackle the public/private pension apartheid by making all public sector schemes CDC – fixed cost for the tax payer. Anybody for bold Government moves?