The first two submissions on CDC published by the Work and Pensions Select Committee come from Henry Tapper and Hargreaves Lansdown. HL’s submission is here – as it appears on the W&P Select site.
I don’t agree with it, but I respect the spirit in which it is written.
The debate on CDC has just begun and I am sure this document should be quoted exhaustively. Thanks Hargreaves Lansdown.
Written evidence from Hargreaves Lansdown (CDC0002)
Hargreaves Lansdown is the UK’s largest direct-to-investor provider of investment services, administering £82 billion of investments for over 1 million clients. Our purpose is to empower people to save and invest with confidence. We aim to provide a lifelong, secure home for people’s savings and investments that offers great value, an incredible service and makes their financial life easy. We provide services for both individuals directly and through the workplace.
- CDC increasingly incompatible with changing work patterns
- CDC would result in higher contribution rates or lower payouts
- CDC risks exacerbating intergenerational inequality
- CDC would require onerous regulatory oversight
Benefits to savers and the wider economy:
Would CDC deliver tangible benefits to savers compared with other models?
- Defined benefit pensions are heralded as gold plated pension schemes. They are great in that members bear very little risk when building up pensions, whereas defined contribution pensions provide no such risk mitigation.
- In principle, defined contribution pensions should be no worse for savers. The key difference is the contribution levels. The average contribution to a DB pension is 22.7%, whereas it is 4.2% to a DC pension, having been diluted down from pre auto-enrolment levels of 9%. Even after the step up to contributions that will occur under auto-enrolment there will remain a significant difference between the two regimes. Therefore, DB pensions are advantageous primarily because they receive far higher levels of funding compared to DC pensions.
- As an example, someone earning £28,000 every year, contributing 22.7% of salary into a DC pension, with 5% investment returns and a 0.5% charge should be in a position to retire with an income of 2/3rds of their final salary at age 60. This not only removes the question of adequacy, it allows individual control throughout the final years of work.
- The drawback for members with DC pensions is the risk of lacklustre investment returns, particularly at the point when returns matter most – prior to retirement. Mitigating this risk is crucial to give good outcomes for DC members.
- CDC has an admirable intention. Sharing risk across multiple cohorts to smooth returns. However, this smoothing of returns principally benefits members who are close to, or in the process of, drawing from their pension. The asset mix to deliver these smoothed returns is likely to fail younger savers who have the potential to take a higher risk approach at the start of their career. By sacrificing opportunity for investment growth, people have to pay more money in or work longer, neither of which is particularly appetising.
- The two factors that have the biggest effect on the size of your pension pot at retirement are how much you pay in and where you invest. The industry is currently fixated on encouraging members to pay higher contributions, but pay packets are already squeezed. It would be beneficial for the industry to focus equally on helping people to understand the merits of pursuing better investment returns, particularly when young, and providing simple solutions to help them do this.
- To put this into context Hargreaves Lansdown has modelled the impact of various factors that can influence retirement income. The output (shown in the chart below) illustrates that someone earning £30,000 can expect a retirement income of just over £12,000 when they pay 10% contributions, receive 5% investment returns, start saving at 22, retire at 68, pay annual charges of 0.75% and receive an annuity rate of 5.79%. It also shows the relative impact of changing these factors. Contributions and investment returns have the greatest impact on the final income.
How would a continental-style collective approach work alongside individual freedom and choice?
- In a world of pension freedoms people need flexibility to draw their pension when they want, either entirely or in part. However pension freedom is only one of the challenges, with the far larger one being modern working patterns. Take work from the ONS, showing the probability of what age people will leave the world of work (illustrated below). Whilst there is some anchoring to State Pension Age, there is a wide distribution. We anticipate this will only become more dispersed as the population becomes older.
- We believe the concept of CDC works best if people are members throughout their entire saving career, however we know this is impossible in practice. Once people start opting out, or worse still asking for transfers out, then it all gets harder to control and administer. Mitigating this impact is important, so allowing those who want to engage with other pension services the ability to do so as soon as practicable is an obvious move. It is imperative that members are granted auto-enrolment personal choice, this is where they have the right to elect which pension service suits their circumstances and have both their personal and employer contributions redirected accordingly.
- We should also remember that collective risk sharing already exists in DC pensions, it is called With Profits and has equally admirable intentions. In this case, a member’s actual fund value could be higher or lower than the net asset value of the underlying investments. To this value could be added regular bonuses which could not be taken away, in addition to a final bonus which could be reduced or removed entirely. These types of funds worked reasonably well in a rising stockmarket, but were generally terrible when the market fell heavily as providers levied a ‘market value reduction’ to reduce peoples pension pots if they wanted to transfer away. They did work well for some people, as the funds often guaranteed points when reductions would not apply, typically at retirement age. Even back in the 1990s when With Profits funds were popular, the notion of a single retirement age was outdated. This is now completely alien to how most people will end up taking money from their pensions.
- Through the lens of CDC, trying to offer the smoothing of returns when access is required across a wide variety of ages, is likely to result in a conservative asset mix acting as a drag on long term returns. This will further impact on younger members who have not benefited from DB schemes in their early career heightening intergenerational inequality.
Does this risk creating extra complexity and confusion? Would savers understand and trust the income ‘ambition’ offered by CDC?
- Introducing a third type of pension saving would undoubtedly add extra complexity. Speaking to members when With Profits funds were at the height of their popularity, there was a general mistrust towards insurers who were managing the money. The funds create a façade of simplicity where people do not having to worry about their money, however underneath the bonnet the cogs are whirring away with often complex structures. Given the move towards greater transparency in workplace pensions around fees, it would be odd to introduce an extremely opaque pension solution. Above all else, the pension system is crying out for greater simplicity.
- There is a huge risk that people will misunderstand CDC. Imagine the person who has been told their pension is targeting a certain level of pension, but it ends up falling short. This person will still be disappointed and resent the fact that their retirement aspirations have not been met.
Converting DB schemes to CDC:
Could seriously underfunded DB pension schemes be resolved by changing their pension contract to CDC, along Dutch lines?
- Converting DB Schemes to CDC sets a dangerous precedent that pension benefits can be retrospectively changed, in addition policing the schemes that may be converted and those that cannot is hugely challenging.
- The Pension Protection Fund plays a hugely important part in the UK pension system and remains one of the key reasons why DB pension transfers remain niche transactions. There is a risk that a threat of an alternative solution would create greater uncertainty for members, potentially increasing the number of transfers out.
How would this be regulated and how would the loss of DB pension promises to scheme members be addressed?
- We don’t think it is feasible. People do not adequately understand the differences between DB and DC and so the watering down of DB will universally taint the pension brand at a time when auto-enrolment is doing great work in improving its image.
Regulation, governance and industry issues:
How would CDCs be regulated?
- Regulation needs to be very heavy indeed. The damage to the industry of a pension that is perceived as offering even a pseudo guarantee failing would be catastrophic.
Is there appetite among employers and the UK pension industry to deliver CDC?
- We don’t believe there is appetite from employers to embrace CDC pensions.
- Their views may well be shaped by the views of their employees. How CDC is explained to employees will also greatly impact on their views on the subject. You are likely to get two very different answers if you posed the following questions to pension members:
- Would you like it if your pension goes up gradually and we aim to deliver you a certain proportion of income in retirement? We cannot promise it, but we will do our best. Is that OK?
- We will put you into a fund that we expect will give you lower long term returns, but you won’t see your fund fluctuate in value. This will mean probably having less in retirement, working longer or paying in more. Does this sound acceptable?
Would CDC funds have a clearer view towards investing for the long term?
- People still need to have the ability to transfer out from a CDC pension and have flexibility to draw all or nothing from their pension when retiring. We think that this limits the scope to invest with more clarity for the longer term. Hargreaves Lansdown research also points towards increased appetite for annuities as people age, which would have to be factored into any design.