Wesbroom
Kevin Wesbroom has been a leading pension commentator since the 1980s for Bacon and Woodrow, Hewitt and no Aon. He is a Friend of CDC and writes tellingly on how CDC might work in post-freedom Britain. This is the first piece I’ve hosted of his, and I’m proud to do so, it won’t be the last! Kevin is writing in his role as a pension consultant at Aon.
In this article, the points in David Blake’s submission are in plain type and Kevin’s responses are in bold italics.
Comments on Written Submission from David Blake
Professor David Blake
David Blake advocates a form of CDC that he calls – somewhat confusingly – Collective Individual Defined Contribution (CIDC) schemes, and argues this might be the only form of collective scheme that is feasible in the short term following the introduction of ‘freedom and choice’. The key features of CIDC schemes in his model are:
- The CIDC scheme maintains individual accounts for all members in the accumulation phase, so it is easy to value each individual’s pension pot
- The contribution rate is set to be actuarially fair to each member, implying that there is a direct relationship between the contributions that an individual pays into the scheme and the pension they eventually receive.
- Each individual has their own de-risking investment strategy in the lead up to retirement.
On these points:
- Valuation of an individual share is not difficult in a WinRS style CDC scheme.
- The contribution rate point is worth understanding. In a WinRS style scheme – eg Target benefit of 1/80th of revalued earnings- the employer contribution might be an average of say 15% of pay. But like all DB style schemes, that is an average rate – which might be say 10% for a younger member and 20% for an older person. David proposes that we “explode” the average contribution rate and offer a benefit worth 10% to the younger member and 20% for the older person (this might well be via some sort of points based system). Both methods are viable and possible under the overall CDC banner.
- If each individual has their own de-risking, they will miss out on the benefits of a CDC plan – by investing for the group, not the individual, we are able to take longer term time horizon and chase potentially higher returns.
“However, theoretical models suggest that CDC schemes are only likely to be sustainable in the long run if (a) everyone joins (i.e., participation is mandatory) and (b) everyone remains in the scheme for life.”
This is a common – and incorrect – accusation about CDC schemes. Our modelling shows how CDC designs can be resilient to schemes starting from scratch, and winding down. In both cases –as with a continuing CDC scheme – the issue is to have a bonus policy which is consistent with the portrayal to member and with the investment policy to be pursued.
“Transfers between schemes are, of course, possible, but this is in theory much easier with IDC schemes – where every member has their own account – than with CDC schemes – where members will simply know their target pension and could be subject to a market value adjustment (MVA) if they transfer.”
In a WinRS style scheme with a Target pension, the transfer value will be assessed as the fair value (best estimate, as in DB CETV calculations) of the Target pension earned to date, with bonuses. There will then be an adjustment – upwards or downwards – to make sure the sum of transfer values for all members is equal to the scheme assets. This way each member gets a fair share of the fund, based on the target benefit.
“… this, in turn, requires that there are only a few large CDC schemes in existence, all fully exploiting scale economies. …This is only likely to be feasible if the CDC schemes are organised, not on a company basis, but on an industry-wide or national basis.”
CDC schemes need scale but not exclusivity, as described above.
“The 2014 Budget introduced greater ‘pension freedoms’ from April 2015 which would allow DC savers to take their pension fund in cash from age 55 … By keeping their assets in the scheme, some would claim that members would be ‘losing’ their pension freedoms. If sufficient savers exercised these new freedoms, it would make CDC schemes unfeasible.”
A Target Lifetime Income (TLI) is a form of CDC pensions that could form the payout part of a WinRS scheme, or could be purchased on a standalone basis by a retiring DC member. A member could decide whether or not a TLI should form part or all of their retirement planning, in a “pension freedoms” world. CDC complements rather than challenges the concept of pension freedoms, and fills a market failure.
“CDC schemes have little flexibility over the age of retirement.”
We are not sure why this assertion is made. In our CDC design, even though the member might have a target or pivotal pension age of say 65, they could take an early or late pension at any age between 55 and 75 on actuarially equivalent terms.
“Members of a CDC scheme have no identifiable pension pot, so the valuation of each member’s claim in a CDC scheme is as challenging as it is in a DB scheme.”
Members of a WinRS style CDC scheme will have a Target Pension. A value can be placed on that pension, exactly as in a DB scheme, and then scaled to give a fair share of fund.
“Ponzi schemes come to a sudden stop when new investors refuse to join. There is, of course, the opposite problem that the first generation in the scheme receive less than their fair share due to the trustees being overly cautious… Related to this is the criticism that CDC schemes cannot work without an ‘estate’ or initial reserve that can be used for smoothing returns. .. it might be possible to start a CDC scheme without an estate, but to require an estate to be built up by the first group of members. In other words, this group takes out less than is justified by the fund’s investment performance in order to build a smoothing fund.”
This is a repeat of the assertion above that a CDC scheme is inherently unfair to wither – or both – of the first generation of members or the last generation of members. Because of this repeated – and incorrect – assertion, we actually undertook some extensive modelling about this. Our 45 page paper, summarizing a material amount of modelling (in contrast to the assertions of others, not backed by any evidence) shows that these generations can benefit from the risk sharing inherent in a CDC plan. This requires the target benefits to be correctly described, and aligned with the bonus and investment policies to be pursued.
“The risk-sharing rules lack transparency …. It could be argued that discretion is the enemy of transparency. Some, however, have argued that some degree of opacity is necessary for such schemes to work at all.”
We agree that a degree of opacity is inevitable with a CDC plan – at least from the perspective of a typical member. Lack of transparency used to drive us mad when dealing with with-profits actuaries. Our counter to this, is the concept of a Public CDC Website. All material relating to a CDC plan – deeds, bonus policy, investment SIP, investment returns, regular actuarial assessments, bonuses granted – would all be available to the general public. Skeptical pensions commentators –such as David Blake! – could review this material and hold the trustees to account, if they felt the actions of the trustees were inconsistent with the financial development of the plan and its prospects. This is a powerful form of transparency, not available in the hey day of with profits funds.
“Some employers might be attracted to CDC in preference to IDC if they could convert their defined benefit (DB) pension schemes into CDC schemes. This would allow DB promises to be converted into non-guaranteed targets in the CDC scheme.”
Not part of our proposals. Only conversions would be with consent.
“I do not believe that CDC has a present: the new pension freedoms are completely incompatible with CDC’s requirement that members stay for life …..For this reason, I recommend that the Government looks at the feasibility of establishing CIDC – for both the accumulation and decumulation phases. Such schemes …would also be compatible with the new pension flexibilities following the 2014 Budget, while, at the same time, exploiting economies of scale to the full and allowing a high degree of risk pooling.”
There are many versions of CDC. We can see there is scope for both to co-exist. We find it ironic that David argues that CDC is both inconsistent with pension freedoms, but his ICDC version is compatible with pension freedoms. Both options need to be offered an opportunity to deliver better member outcomes for members, for common reasons described by David Blake.
“The sad reality is that vast numbers of people in this country do not understand their pension scheme or how it works.”
Agree that.
“I see little current appetite from employers.”
We do
“The pension industry is keener, especially the actuarial consultancy industry, since it needs to find a revenue stream that replaces that coming from the dying DB industry.”
Another regular cheap shot. Given the limited numbers of CDC schemes, they are hardly likely to be the job creation scheme that actuaries might want.
“… it is more likely that a multi-employer trust-based scheme (like NEST) would find it easier to do this if there were sufficient appetite amongst scheme members.”
Agree that – restrictions on NEST should be removed.
“CDC ought to be attractive to public sector employers with DB schemes which have precisely the same problems as their private sector equivalents.”
As a taxpayer, I can only agree that I would prefer the fixed cost element of a CDC scheme.
Having operated CIDC for 5 years before being abandoned through lack of industry support, I would like to point out that there are fundamental difference in the two systems, which are crucial to understand – flexibility, individual control, absence of residual sponsor risk. We now offer the same low grade DC system the industry and government seems to demand. I can understand the reason CDC was spawned as an idea, it’s just the wrong idea.
Kevin asserts that you can identify different actuarial values fo reach member. But CIDC is not about “identifying” your share of fund, it’s having the flexibility to adopt a de-risking or up-risking funding strategy appropriate to individual needs.
CIDC came about as a means of employers funding the same DB target, post closure of DB accrual. Rather than the same DC contribution as with most sponsored DC schemes, the employee paid a fixed rate and the employer paid the required top up derived from an individual actuarial funding calculation with a pre determined discount rate assumption appropriate to a default de-risking strategy. Each individual had a different employer cost, as it is with a DB plan.
Kevin can argue that, given the same assumptions, the sum total of funding is the same as the aggregate funding as if it was CDC and would not argue. However, what CIDC allows is for the individual to pull some levers to impact the projected outcomes – (1) his personal level of contribution, (2) a more or less aggressive de-risking strategy, (3) a different retirement date and (4) how much of his target income (proxy for a liability) will be 100% matched.
What seems an impossible range of choices is reduced to a simple speedometer showing the probability of reaching your target given how you have pulled the four levers. You don’t need to know how they are impacting, simply a picture of reality, that if you want to retire at 55 with a 66% pension and aggregate contributions of 10% and maximum exposure to growth assets you had between zero and 5% chance. If you don’t touch the levers the pre-determined default applies. That pre-detremiend default takes account of – assumed state pension (able to be modified by the employee), intended age of retirement, age, gender, salary, inflation, mortality and contributions due. These are adopted by the sponsor/trustees with actuarial advice. They are applied to each individual to derive a default feasible replacement ratio with a probability number set by the sponsor/trustees, say 70% consistent with the default assumptions.
It is simply a DB scheme with an employee rather than an employer covenant where each employee decides replacement ratio and risk. Where CIDC was first employed in the Netherlands as a DB replacement scheme it allowed individuals with a pre-existing right to guaranteed DB and state benefits covering a high percentage of an adequate replacement ratio to accept a higher allocation to growth (more risk) to show a higher feasible income but with a lower probability of achievability.
Why has this seemingly perfect DC model as a replacement for DB never taken off? I suggest you ask the employee benefit consultants. In my experience it was too radical and did not meet the perceived view that a DC scheme is only about being able to choose investments. Employees have been convinced by both regulators and advisers that control of asset returns means control of outcomes. Strange then that it is accepted by the same bodies that DB scheme outcomes cannot be improved by maximising asset return and a level of liability matching is received wisdom. A DC target is no different from a DB liability if recognised as an income target rather than a capital accumulation target.
CIDC allows individuals to apply actuarial methodology to suit their needs without having to know the sum of 2 + 2. The obsession with CDC has hindered any development of CIDC. Far be it from me to suggest that it offers less involvement of teams of actuaries compared to CDC, given individual actuarial updates can be done on the fly in CIDC to produce individual asset re-balancing instructions monthly, quarterly or annual as required.
Risk sharing of investment returns is a weak plank to justify the hype of CDC. It assumes there is no upside to taking higher risk and no upside to taking lower risk. It presumes averages work for everyone whether a 60 year old on low salary with 90% of his income already secured in DB and state provision wanting to retire at 75 or a 20 year old on a high salary with no existing secured rights wanting to retire at 55. CIDC allows the risk of not achieving a desired income to be identified and potentially managed by providing the levers to make changes, and a realistic picture of the financial implications. CDC should have been devised before DC became the norm. It is simply an anachronistic concept.
CDC has a place in risk sharing during de-cumulation, where an individual is least able to manage mortality and investment risks. CDC misguidedly implies that to achieve investment/mortality risk sharing post retirement, you must have investment risk sharing pre retirement. That is a fallacy, as are the claimed reduction in costs, made when CDC was being compared to retail personal pensions schemes with outrageous commission charges.
Advisers, and in turn employees, do not currently acknowledge that DC is anything other than a capital accumulation exercise and investment advice, supported by Regulatory guidelines, is the key to successful DC outcomes. It is in the self interest of too many in the industry to perpetuate those ideas, and until that changes no advancement of DC funding towards CIDC, let alone CDC, is likely.