In a risk-obsessed world, Con Keating observes that it’s its absence of risk-management that could be CDC’s greatest boon to the young.
The new member joining a collective DC scheme is contributing marginally to a collective fund. This fund is itself the result of the prior contributions of all living members. It may be in surplus or deficit relative to the equitable interests of its members. If in surplus, the new member has an immediate windfall gain, if in deficit an immediate loss.
The fund itself, when annually valued will rise or fall by the experienced annual gain or loss, as would any exposure to the market. This occurs not just in the years when a member is contributing but also when withdrawing his or her pension. With individual DC, the sensitivity of the value of the fund to market volatility is usually the justification for de-risking the portfolio of an individual, by moving to safe assets. This has a cost. Historically, from 1980, the compound returns to risky UK assets have been 7.73% pa versus 4.68% pa for safe bonds and bills.
The new member of a collective scheme may only be making contributions in the first 40 years until retirement but will also benefit from the reduction in volatility due to the contributions, effectively pound cost averaging, of active members during his or her retirement.
It is surprising how many fail to realise that assets do not need to be explicitly bought or sold for market volatility to have an effect on portfolio outcomes. If the volatility is 10%, the difference between the realised annual average return and the compound, or geometric will be 0.5% pa, if the volatility is 20%, then it will be 2% pa and if 30%, then the difference will be 4.5% pa.
The continuing nature of the CDC fund also renders immaterial an important risk associated with individual DC in drawdown, that of sequencing, whereby it may prove impossible to recover from an early sequence of poor returns. The new contributions due to active members actually benefit from the depressed prices of such sequences.
These should be powerful incentives for younger employees to join a collective rather than individual scheme – the post retirement investment outcome of the collective is more than twice that of the individual. As longevity increases, this disparity will grow.
In various other articles, we have explained the risk sharing characteristics of the uniform accrual or award – that a member receives some proportion of final salary for each year of service and contribution regardless of their age. When expected returns are high and contribution rates low, this arrangement favours the old over the young. When expected returns are low, and contributions high, it favours the young over the old. But this is an incomplete analysis; when expected returns are low, contributions are high, and vice versa, a situation which offers further comfort to the retired members.
The long-term nature of the investment funds in a collective pension scheme should be expected to influence the choice of asset allocation strategy. Such schemes should be expected to be concerned with investment rather than speculation, to be attempting to address the economic problem of securing claims on future production. They should be expected to be committed to infrastructure and unlisted private securities based on their long-term fundamentals, rather than operating in short term speculative traded markets.
Today’s listed companies account for only a small proportion of current economic production, and can be expected to account for an even smaller proportion of future production at the horizons of pension schemes. In addition, there is an explicit drag on the investment returns of marketable, traded instruments, albeit declining with the holding period, due to the cost of liquidity. These traded instruments are also inexplicably volatile relative to their fundamentals; in some empirical studies by as much as four times more than their fundamentals, such as dividends.
It is unfortunate that we rarely see this predicted investment behaviour in DB schemes today. Here concerns with the sponsor guarantee have come to dominate. Rather that pursuing some long-term optimal asset allocation strategy, the investment policy has become fixated on the solvency of the scheme and the resultant deficit repair calls on the sponsor guarantee.
This has led to “de-risking strategies”. We have seen schemes moving from servicing the guarantee when required, to attempting to fund it; a manifold multiplication of the costs of the guarantee.
If, naively, we consider CDC arrangements as no more than a traditional DB scheme minus the sponsor guarantee, and it associated costs, it becomes obvious that we may reasonably expect them to deliver superior outcomes than we have seen from traditional DB recently. The cost of the sponsor guarantee expresses itself through several channels; through explicit deficit repair contributions, through overly cautious asset allocations, through depressed wage growth, and arguably, through the social costs of the cessation of provision.
Importing, through regulation, the “risk management” methods of traditional DB is misconceived and seems likely only to produce the same results – the death, or in this case, still-birth of CDC.