This is the third of three blogs from Con which will in future appear in Professional Pensions.
The idea that individual DC will produce pension outcomes that are satisfactory for the majority of retirement savers is now thoroughly discredited, as is evidenced by even a cursory reading of the Social Market Foundation’s “Golden Years” report. The early experience of withdrawals under Freedom and Choice reinforces this conclusion. Indeed, even the neoliberal advocates of individualism, education and competition have begun to shift their ground and are suggesting that new measures of pension adequacy are needed to cope with the disparate non-pension uses to which these savings are now being put. This verges on the farcical: my new conservatory and caravan as indicators of retirement income adequacy.
Some appear to believe that the solution to these issues lies with greater consumer education and the debate moves to guidance and advice. These solutions fly in the face of experience – mass financial education does not work. Even if it did, as numerous studies have concluded, competition has not delivered the desired results for the consumers of fund management services. Fund management seems to be demand inelastic. The annuities market was a prime example of such a situation; the costs of regulation and marketing restricted what could be profitably offered by the insurance companies. In time of low investment returns, their basic feedstuff, annuities became singularly unattractive, in large part due to these and other fixed costs.
It is worth understanding the relative importance of the two elements of an annuity or drawdown, the return of capital and the income earned in the post retirement period. By way of illustration, consider a thirty-year uniform annuity that experiences either a 2% or a 10% constant investment return. The annuity (per £100) would be £4.45 in the 2% case, and £10.61 in the other. The relevant aspect here is the changing importance of the return of capital – it is 55% of the annuity income in the 2% case and just 5.7% in the other. The ability of low investment returns to absorb fixed costs is clearly limited. The good news here is that the degree of self-harm being done by the current withdrawals under Freedom and Choice is less than it would be in more normal times.
It is paradoxical that the neo-liberal financialisation agenda does not continue to its logical extremes; individual DC saving, at least in the mass market, utilises collective investments – the individual’s responsibility is simply choice, as a price-taker, among these funds. This is frequently, and incorrectly, described as risk pooling. In fact, this is acceptance by all subscribers of a common risk and return, with some possible advantages over (informed) individual management accruing from economies of scale and scope. One of the analyses of value for money that does not exist, but should do, is comparison of the value of an individual’s time and effort with the fees charged for fund management services.
While competition is a very powerful economic mechanism, it is not in all circumstances the optimal approach; in many circumstances co-operation is superior. Co-operation consists of risk pooling and risk sharing among the collaborators, and exists because it is both powerful and benefits all. It is widely present in both nature and human endeavour. A simple illustration is appropriate. Consider two funds, A & B, owned by different individuals, which have mean returns of 5% and 7% respectively, with volatility of 10% and 20%. The long-term compound expected return of fund A is 4.5%, and of fund B is 5%. If we pool the funds and agree to share equally the outcomes then both will achieve long term returns of 5.375%.
The recent Pensions Policy Institute study of CDC, commissioned by the Department of Work and Pensions should have laid to rest any doubts over the benefits of CDC relative to individual DC. Three of their findings warrant mention:
•In the long term, once the scheme is mature and the scheme population is stable, CDC produces better outcomes (a replacement rate of between 27% and 30%) than DC (a replacement rate of between 12% and 21%, assuming a 10% contribution rate). The PPI modelled CDC scheme also requires a relatively low contribution rate to maintain these outcomes.
•In the short term, with no initial pre-funding (which is likely to be the case for a new scheme), the benefits of the modelled CDC scheme are similar to that of a DC scheme with an aggressive drawdown (7% per year). However, the modelled CDC scheme would be less likely to run out, and the outcomes are still higher than a DC scheme with an annuity.
•The modelled CDC scheme has a narrower distribution of outcomes than DC.
In other words the study reports similar findings and benefits to the earlier Aon and RSA studies. Having criticised earlier (in Decumulation – Part Two) the actuarial asset, liability and solvency approach to pensions, it is worth noting that cash flow projection methods produce similar positive outcomes. This PPI modelling accords well with theory, where both the investment and longevity insurance elements are mutually, absolutely, and meaningfully beneficial. It is regrettable that, due to pressures of work, the DWP has deferred the introduction of legislation to enable CDC.
The idea has been floated of using CDC simply for the decumulation phase of DC saving. In decumulation alone the obvious difference is that there is also no link to (former) employment, and new savings contributions are not being made, and in the full CDC model this cash flow offsets to a large extent the pensions being paid, reducing dependence upon financial markets. However, the decumulation CDC will be taking in pots of assets from new members, in specie – some of which will be in cash.
The CDC is in effect offering an annuity to new members, albeit a soft promise that can be reduced or increased. The PPI modelling, showing outcomes from CDC that are superior to individual DC with annuitisation, suggests that superior terms can be offered that provide an incentive for new members to join a decumulation CDC.
By taking in assets in specie, the decumulation CDC is risk pooling and risk sharing, as illustrated earlier, and this portfolio can be rebalanced, as desired, over time. (Decumulation Part 2 discussed some relevant assets and instruments.) Further, the longevity insurance aspect benefits all members. This is nothing new; the history of the life assurance industry is replete with mutuality and co-operation. The modelling of CDC so far has considered only variation of the pension incomes payable, but decumulation CDC can also vary the terms of entrance of new members into the scheme. Even the primary roadblock, that of early death and the total loss of the savings pot, to entry into such an arrangement can be surmounted. Preliminary analysis suggests that similar refund guarantees to those of conventional annuities can be offered, without harm to the CDC scheme. If, as has been proposed, a secondary market in annuities is developed, the CDC scheme could be present as both buyer and seller, but the CDC scheme should not allow redemption of its annuity promises at the option of the member, as that runs counter to its entire ethos.