Traditional funded private sector occupational DB pension schemes are showing signs of advanced senescence; they are proving mortal. We could debate the role of regulation, accounting and management practice in that decline, but there is little purpose, as the prospects of rejuvenation, let alone resurrection, are extremely remote. No rational finance director is likely to expose themselves willingly to any repeat of the chronic pain and suffering of recent decades. Predictably, far too much of the pensions industry is focussed upon palliative care and burial rites.

Individual DC is no phoenix arising from these ashes, rather more a cuckoo; these are not even true pensions arrangements, just tax-advantaged savings schemes. Recitation, here, of the litany of problems of individual DC would just add echoes to that turgid, sepulchral drone. The obvious question is: can we do better?

The answer to that is an emphatic yes. Not only can we deliver better outcomes[1] than individual DC, but it is even possible to surpass the outcomes of traditional DB. The answer lies with collective defined contribution (CDC).

There have been at least 8 studies and simulations of the relative performance of individual and collective DC; all have concluded that CDC is superior on average to individual DC. The reason for this, in most of these studies, is that the investment horizon for CDC is far longer than for individual DC, where the transition from saving to decumulation is costly in several ways. The CDC scheme by contrast maintains a consistent long-term investment profile. The difference is not trivial; over recent decades, the returns to risky investments have exceeded those of safe assets by around 3% pa. This represents a doubling of the post-retirement investment income. Of course, individuals do, by and large, invest in collective funds, but that is an extremely limited form of pooling. Its limitations are evident in the variation of the experience of member outcomes, and the decumulation transition rests on top of that.

The reason for the outperformance of CDC relative to traditional DB differs from this. If we think of CDC just as DB without the sponsor guarantee, and then we recognise that such guarantees are costly[2], it becomes obvious that CDC may outperform. 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. In large part, the guarantee cost has gone ballistic as sponsors have moved from servicing or performing under the guarantee to “de-risking” and eliminating its potential future financial consequences.

No pension scheme can be sustained if it operates inequitably among its members. This observation motivates the development of a metric for a member’s equitable interest for use with CDC schemes, and with that the aggregate interest in the assets held by a scheme[3]. A defining characteristic of these CDC schemes is that they have no explicit liabilities, and consequently can have no contractual recourse to external guarantors or insurers. However, the member’s equitable interest may be considered as a pseudo-liability. From the lack of discussion of this, it appears that a “secret sauce” in CDC schemes is that this pseudo-liability is not fixed and may be managed. In traditional DB, liabilities are explicit and in the absence of member consent, their inviolable property. The liability management possibilities there are intrinsically binary, present or not.

The problem reduces to a schema which accurately captures the interests of each and every member while also encouraging solidarity among those members. Through collective risk-sharing and risk-pooling, it should provide explicit benefits to members and offer an incentive to younger non-members to wish to join the scheme. With CDC, a member’s equitable interest reflects their proportional interest in the assets of the collective at any point in time. It is an equitable scheme of arrangement among members.

In the setting of contributions, trustees need to have regard to the value for money offered to members and the expected returns on scheme assets available to them. In this process, there should be neither subsidy of deficit repair nor, when in surplus, over-attractive terms for new members.

It turns out that the uniform award structure of traditional DB arrangements satisfies this scheme management requirement. It does so through the contribution setting mechanism and embeds this into the scheme. This is the mechanism, in traditional DB, whereby the contribution for a year of service confers an entitlement to some defined accrual, say 1.5% of final salary, regardless of the age of the member. With CDC schemes, this “entitlement” is a best efforts endeavour, not a contractual commitment.

There is risk-sharing present. When expected returns are high this mechanism favours older members more than younger, and when expected returns are low, it favours the young over the old. This is a reciprocating risk-sharing mechanism, established ex-ante, which should benefit both classes of active member. In traditional DB, this is present, but rendered redundant by the presence of the sponsor guarantee.

There should also be a separate ex post mechanism which operates when scheme assets are less than the aggregate equitable interest, a situation which might be described as “in deficit”, where pensions in payment are at risk. This is a support mechanism for pensioners, who will still receive the full amount payable were the scheme fully funded. Along with this support, the non-pensioners in the scheme see their equitable interest increased by similar proportion. There are limits to the extent to which non-pensioner members may be permitted to do this. In the situation where pensions are cut, then non-pensioners’ equitable interests are reduced in similar proportion to the pension cuts. Both cuts and support operate on a year by year basis and are applied only to that year. Students of game theory will immediately recognise this as a situation in which co-operation is rewarded and defection penalised.

As noted earlier, such risk-sharing needs to be limited, so as to avoid the possibility of asset depletion to the point of no return, no recovery and a so-called “death spiral”. But it turns out that the risk of calls for support in excess of 10% of members’ equitable interest, along with limitations on the term of forbearance, has historically not been experienced. In simulation, the likelihood of a cut to pensions was less than one in a thousand, with the ongoing scheme be sustainable – the security offered by this arrangement is actually far superior to that of most sponsor guarantees.

It is often asserted that no new member will join a scheme which is deficit. In fact, these new members are being offered fair, good value for money terms, with the prospect of an immediate increase for co-operation in the support of pensioners in payment. Responsible self-interest should be expected to prevail.

CDC schemes offer the prospect of sustainable, higher, more secure outcomes, that are equitable among members, and which bring the added comfort of greater predictability of retirement provision.

[1] Technically, the outcomes exhibit second order stochastic dominance.

[2] With perfect foresight, there would be no cost to the guarantee.

[3] The concept of the equitable interest of a member is explored more fully in: http://www.longfinance.net/news/long-finance-blogs/1148-the-design-and-operation-of-cdc.html

This article first appeared in Portfolio Institutional

Con Keating is a regular writer for this blog.

Con is currently a member of the steering committee of the financial econometrics research centre at the University of Warwick and of the Société Universitaire Européenne de Recherches en Finance. As a research fellow of the Finance Development Centre he published widely on the regulation of financial institutions and pension systems, and also developed new statistical tools for the analysis of financial data, such as Omega functions and metrics.From 1994 to 2001, Con was chairman of the committee on methods and measures of the European Federation of Financial Analysts Societies and currently is a member of their Market Structure Commission. Con has also served as an advisor and consultant to the OECD’s private pensions committee and a number of other international institutions.

In a career spanning more than forty years, Con has worked as an infrastructure project financier, corporate advisor, investment manager and research analyst in Europe, Asia and the United States. He has served on the boards of a number of educational and charitable foundations and as a trustee of several pension schemes. He is currently Head of Research for the BrightonRock insurance group.