Some pension promises are easy to value
If I promise to pay you a monthly amount over the next five years, it is fairly easy to work out the value of that promise. At it’s simplest level the value is just the sum of the 60 payments though I may want to apply a discount to the value as by the time I get some of the money, it won’t be as valuable as it is today (inflation does that to money!).
But if I promise to pay you a sum of money over the rest of your life, then the sum is a bit harder as I have to guess how long you are going to live, the discounting will (hopefully ) be over longer.
But in both cases , the sums aren’t that difficult and reference to simple tables allows a mathematician to value the promise in pounds shillings and pence.
CDC promises are harder to value
But this is where it gets interesting. The new CDC pensions have some certainty, we can value what’s going in and estimate what that might buy you by way of a lifetime income at the point of investment, but what you get is subject to the markets and not to a guaranteed formula..
So every payment made into a CDC scheme buys a right to a share in all the pensions paid out by the Scheme but not necessarily a right to a share in the fund. This is quite hard to get your head around but think of it this way.
Whoever runs the fund is trying to ensure fairness about the way it is spent so that there are rules that people feel comfortable with. Life is not entirely fair, some people find that the timing of investments works against them, others end up spending their pension for shorter than others. It may be that some generations get luckier than others.
Trust , transparency and good rules
But these general unfairnesses are bearable as long as we know the rules. People don’t like negative equity in their property but they accept that the price of a house can fall as well as rise. It’s not particularly fair if you are owning a house in Northern Ireland and see property prices shooting ahead in London but you knew the rules when you purchased.
Valuing the future promise not the present value
We have got used to valuing our pension savings with reference to a unit price. Multiply the units held by the unit price and you have the residual value of your pension pot. This is what happens on the way up (the saving phase) and this is what happens on the way down (drawdown).
But CDC may not work like this. Instead it may work on the basis of the amount the person running the scheme has put away to pay you your pension, and that value will be dependent on what’s happened before- (the timing and incidence of your payments, plus the investment growth since they were made). It will also depend on an estimate of what’s still to come (how long you are expected to live and the amount of discounting going on).
With CDC, neither the value of the capital or the pension is constant.
Now this is why everyone is getting so aerated about CDC. Whereas DB offers a guarantee of the pension in payment and DC a guarantee of the capital value of your savings, CDC offers no guarantees at all.
And without a guaranteed value, it’s tough on the tax-man!
How , for instance, can the value of a CDC pension be assessed by the taxman for your lifetime allowance. DB plans have a straight 1 for 20 formula while DC plans are valued on the capital value of the units, but CDC transfer values depend on a whole range of factors , at the discretion of the Scheme manager.
Discretionary values – a charter for Mr Ponzi?
This is why John Ralfe refers to CDC schemes as Ponzis, because a Mr Ponzi , or Mr Maddorf or any of the other crooks who dish out promises with one hand and spend member funds with the other, could be at work here.
It is perfectly true that CDC depends on trust and John Ralfe and others know that the best way to test trust is to robe and ask the awkward questions.
The really awkward questions for CDC Schemes will always be about whether they are spending too much on people’s pensions or spending too little.
Are they reserving too heavily, or operating at a deficit?
Are the property rights offered to you by way of a transfer value unfair on you or others in the collective?
The answer is that there are no definitive answers
… the answers to those questions will always be “that depends”.
The dependency is about what will happen in the future, how long the people in the scheme will live, how much support will come from new people joining the scheme and what the markets will do to the underlying fund.
But…and this is the point of this blog.. we are a country that has a very mature attitude to notional property rights. We are a country that understands the difference between a poorly run scheme and a well run one.
When something goes wrong as it did with Maxwell and Equitable and Lehmann Brothers, we accept that these things happen. I am quite sure that a CDC scheme will get into trouble at some point. NEST has been subject to a multi-million pound fraud, State Street nearly got away with stealing millions from the Sainsbury’s pension scheme, people are living on annuities which are half what they should be.
But we also know that the pension system we are part of is under immense scrutiny from Government downwards and that whatever emerges as a CDC pension scheme will need to be scrupulously managed. Every decision on how to distribute , how to value transfers and pay individual payments must be open to scrutiny and rigorously tested.
Is there enough trust in the pension system to tolerate this?
The slogan of the Pension Play Pen Linked In group is “restoring confidence in pensions”. If people have confidence in pensions, CDC will be given a try, if it fails – people will have the right to feel let down and will rightly point the finger at people like me.
I do believe we can have fair property rights in a system of pension payments that depends on discretion. It won’t always be fair and there will be times when mistakes are made. There will be bad practice as well as good practice but I strongly feel that we live in times when it is easier to see through to the core of things (mainly because of advances in information technology).
May this debate continue, it needs to be had, but may it continue in the public arena and not the arcane corridors of power that obfuscate rather than clarify.
CDC is about trust – not about certainty – and that goes for property rights too!
We can value pensions , we can even value CDC pensions, but valuations must be based on trust and not the spurious accuracy of a purely market based approach.
This article first appeared in www.pensionplaypen.com/top-thinking