When I started out in insurance my sales manager told me: “Don’t sell a solution until you’ve understood the problem.”
So far, collective defined contribution is a solution that is so short on detail we can only suppose what it will look like and how it will work. As CDC schemes will not be opening their doors until summer 2016 at the earliest, many people consider that too late, and are asking: “What’s the point?”
However, this article will explain it is not too late for CDC to help individuals and companies. It uses three case studies to explore how CDC could be successful, and runs through some of the actuarial ideas behind the solution.
But before we look at the solutions, let us try and define the problem. The problem is neatly summed up in an email I received from an IFA friend: “Who would want to give advice to most retirees?”
Small pots are best cashed in, big pots can go to drawdown. But those in the middle are just too difficult to call. Should the investor cash in and be left with nothing? Buy a pitiful annuity? See savings eroded by the costs of drawdown?
An adviser would be lucky to avoid a mis-selling claim whatever they decided to recommend. From April 2015 advising ‘those in the middle’ will be fraught with risk, and there is no certainty of earning a fee.
Without annuities in the toolbox, and with drawdown too expensive, those with less than £100k in the DC pot have few options and less advice.
The ‘squeezed middle’ needs a non-advised product that they can understand. CDC is designed to be that product. Let us look at how it might work.
Case study 1: Gary will be 55 in 2016. He currently has £60,000 in four DC pots. He has no intention of stopping working, but he is worried that he may lose his job or have to work on a zero-hour contract with less certainty of income. For now Gary wants to roll up his savings. He knows he will need them to provide him with an income but he does not know when.
Gary wants a simple, flexible solution that will give him a decent income from his investment. He decides to transfer his pots into a CDC scheme.
Case study 2: British Ball Bearings (BBB) employs an ageing workforce – about 30 per cent of them are over 50. The company wants to downsize the workforce but cannot force old workers to retire. It needs to make retirement more attractive.
Case study 3: Marigold Underwriters Ltd fund a ‘legacy’ defined benefit plan for long-serving staff and a group personal pension for newer hires. The new staff feel they get a worse deal.
When BBB asks its staff about retirement, they want advice. So BBB approach an adviser to run seminars for the over 50s.
At the sessions the options are laid out; the cash option is discussed. Many, especially those with debts, want to cash out. Those who have large pots are encouraged to look at the flexibility of individual drawdown. Everyone is offered membership of a CDC arrangement which the company agrees to offer as an alternative to the existing workplace savings plan used for auto-enrolment.
There is common consent that all staff in future contribute to a CDC plan which offers something ‘in the middle’.
After agreeing on a CDC solution, the DB scheme closes for future accrual, and arrangements are made to transfer the GPP into the CDC plan.
Solution: Gary, BBB and Marigold need a common solution – none have enough buying power on their own. Could one collective arrangement deliver an alternative for Gary and BBB’s staff, and satisfy both the DC and DB memberships of Marigold?
All the building blocks are there: the multi-employer master trust for proper governance; suppliers to meet every administration and advice need; and a pensions regulator.
What is missing is a simple and effective funding strategy that makes sure the money never runs out and that everyone gets fair shares.
I asked one of my company’s most brilliant actuaries, Derek Benstead, for his plan for the investment and funding strategy of a collective DC scheme. His response was bold, simple and seemed intuitively right – so here it is:
1) Put the contributions in an index-tracking UK equity fund.
2) Use an actuarial valuation to set target benefits of equal value to the contributions. The assumed rate of return in the valuation does not need to be debated, it can be the dividend yield, which can be checked daily in the Financial Times.
3) The annual increases to the target benefits will follow dividend growth.
The pension outcomes will, for better or worse, reflect the economic performance of the UK. CDC pensions will neither fall behind the wealth of others in the economy’s good times, nor be an unsustainable burden in the economy’s bad times.
Pensioners continue to share in the performance of the economy after retirement. They do not have to buy an annuity, which would lock them into the low guaranteed returns of bonds.
The target benefits have been set up to relate closely to the income generated by the assets, the reverse of the well-known process of matching the assets to the liabilities. The funding and investment plan is stable and should not need extensive advice and reconsideration at each valuation.
The same actuarial valuation which sets up the target benefits for the contributions coming in can be used to calculate the transfer values for members wishing to leave the scheme. Only one actuarial valuation is needed. The target benefits of a CDC scheme should be set up without bias – that is, a best estimate plan. In the probability terms used by the Pension Schemes Bill, the target should have a 50 per cent chance of being delivered. To set a higher probability would mean setting a lower target, which would be unfair on the members while the scheme is growing.
If the scheme later shrinks, there may be a windfall to the members at the time. Whatever benefit probability targets are set in regulations, CDC scheme trustees should nevertheless have a best estimate plan.
A CDC scheme can deliver an income for life based on the performance of the economy. Running a CDC scheme should be easy. This may sound like ‘fantasy pensions’, such a simple model sounds pie in the sky. But most good ideas are simple, like the changes in the Budget – and the Budget cries out for fresh thinking.
We now have a draft Pension Schemes Bill which can allow a scheme based on these principles to work. George, BBB Marigold and many others like them have the possibility of collective benefits that will help restore confidence in pensions.
This article first appeared in FT adviser