This essay compliments my blog this morning. Con Keating is the author of this blog – our thinking is coincidental, though our manner of expressing it – is not!
In all of the discussions of the minutiae of the many possible variants of defined ambition pensions, we run the risk of losing sight of the more complete picture. This is not helped by an absence of commonly agreed terminology.
In this article, we will refer to schemes as being CDC if, when stripped of all else, they revert to being simply the individual DC (or money purchase) arrangement with which we are familiar; reversion to a DB arrangement as CDB. The management and governance needs and arrangements of these two polar forms are markedly different. It is rather obvious that the enabling legislation (Pensions Schemes Act 2015) was written with CDB rather more in mind than CDC. We use defined ambition as the collective term for both forms.
It should also be recognised that some forms of CDC and CDB may be created as things currently stand. However, what may be created within, or more correctly, without, the current rules is typically not fully that desired, or indeed optimal. In addition, few are willing to expose themselves of the possibility of being held hostage to future regulatory developments; a mentality conditioned by the experience with DB over many decades.
In order for pensions arrangements to be sustainable, they must be equitable among members and affordable to them. Put another way, they must be seen to be fair and offer good value for money. This question of fairness has long dogged DB pensions. Unfairness among members, an insolvency priority ordering which heavily favoured pensioners in payment over active or deferred members, was the root cause of much of the legislative change we have seen since the early 1990s. It had some memorable moments, such as semi-naked pensioners protesting on the beach in front of the governing party’s annual conference.
It continues to this day, albeit in a far more complex fashion, in the payment rules for PPF compensation. DB pensions have been further blighted by an extension of inequitable treatment to the sponsor employer, with the result that schemes have closed, and the cost of the employer’s guarantee has exploded.
A key starting point with defined ambition in all its forms is that these have no recourse to external assistance; the scheme has its finite asset portfolio and no more. No scheme, however well-designed, can pay out more than it has. This makes it all the more important that the scheme is able to maximise the portfolio’s value. This motivates the collective fund which may profit from economies of scale and scope relative to individual DC. It does not mean that CDC schemes are unable to insure themselves externally and commercially, should they desire, against their perceived risks – the insurance policies would just be assets of the scheme.
Numerous studies have simulated portfolio outcomes for individual and collective DC. Without exception they have concluded that the collective brings superior results. In large part, this is because the decumulation phase of individual DC is wrapped into the CDC model. This avoids the need to lifestyle or de-risk the asset portfolio, or to annuitize at rates prevailing at time of retirement. The effective unconstrained investment horizon extends from a working lifetime to a full lifetime. This is material, of the order of 25% of total return by the most elementary of calculation.
The CDC scheme is genuinely long-term in nature – a sustainable scheme is sempiternal. This brings consequences for the way in which it should be managed. In the long-term, the management of the portfolio reduces to a question of maximising scheme income over its enduring (and perhaps perpetual) lifetime; this is not the return optimisation, mean variance or otherwise, so heavily promoted by investment consultants.
The liquidity premium cost of traded investments should reduce, in the limit, to its current yield cost. In addition, schemes should be prepared to acquire far more untraded or unlisted securities than is currently the case for either DB or individual DC, which may be expected to reduce the portfolio price volatility further, since they are less exposed to the unexplained animal spirits of traded market prices. As this is often misunderstood, it is worth reiterating that the long-run compound geometric return experienced is reduced relative the annual arithmetic return by volatility, even if no transactions are undertaken.
One way of defining long-term investment relative to the short-term (speculation) is by the source of the cash flows. The long-term being defined by income emanating from the instruments purchased, with the short-term by income derived from markets. The emphasis on listed securities currently imposed by legislation is misconceived. The CDC investment problem may be considered a matter of climatology rather than the meteorology of markets.
The emphasis in regulation on the immediate solvency of DB schemes is a major factor inducing short-term behaviour at the expense of the long-term. Hedging is intrinsically short-term in nature. The effects of this explain much of the mediocre performance of DB funds in recent years.
In economic terms, a pension is a claim on future production. Today’s financial assets are a current claim on part of that production. Government securities are reliant on the ability to tax that production in the future. Current private sector securities are also claims on that future production but limited by the extent to which today’s producers will also be tomorrow’s. The case for long-term investment rather than short-term speculation is well-established. Even a series of optimal short-tern successes cannot be expected to be superior to the long-term optimal.
Perhaps the simplest way to look at the relative performance of CDC funds relative to DB, which theoretically have similar horizons and opportunities, is to view CDC as being DB without the costly sponsor guarantees subtracting from their performance.
A further defining characteristic of defined ambition is the ability to vary the benefits “liability”. With DB the liability is well defined and immutable without member consent. With individual DC, there is no well-defined benefit at all; it is properly seen as a tax-advantaged savings scheme, rather than pension. Theoretically, this may be regarded as adding a degree of freedom or as completing an under-determined problem. In a practical context, it may find expression in the hoary chestnut as to whether we really should increase contributions massively when expected investment returns are low. The risks faced under DB and DC differ markedly. For DB, it is sponsor insolvency when the scheme is in deficit relative to the cost of replacing those benefits in a market. This consequence of this risk is not faced equally by all members, as is well demonstrated by the PPF payment rules. With DC, the risks until retirement are those of any invested savings, but at retirement there are risks associated with the process of conversion of capital to retirement income. The variability due to this risk exposure has a systemic cost (relative to DB or an arrangement which incorporates the decumulation phase) of the order of 1% per annum in returns terms.
The benefits promised in a CDC arrangement are promises not guarantees. The projections of their value are a matter of judgement and discretion for scheme trustees, as is the pricing of new awards, the setting of contribution rates. In this process the trustees must consider the value for money of their offering relative to opportunities available elsewhere to these individuals, and most importantly the expected return that they might achieve on their assets over the term of the award. The assumptions driving benefits projections are also determined by the discretion and judgement of the trustees. Prudence really has no part here; the concept is vacuous and misleading in context. There certainly should be no consideration of any distribution of pre-existing surplus or remedy of deficit in this pricing process; to introduce either would introduce inter-member inequity.
The governance of scheme trustees is critical when they are endowed with discretions. This motivates a “fit and proper” test for eligibility. This is a question of demonstration of the ethical and moral norms of trustworthiness that warrant the placement of trust in fairness of operation by members. The preservation of trust by members is a central concern in a voluntary arrangement. The members should have both exit and voice available to them in the governance of the trustees. Voice through a one man one vote in annual meetings and the approval of financial statements, and exit by way of transfer out at the net asset value of their interest in the fund. The one man one vote criterion does tend to favour the young over the older members relative to a system where the voting power might be by value of their interest. This is consistent with the solution to “commons” problems and with the enduring sustainability of the scheme. Contrary to popular belief, transfer out should always be feasible without detriment to the residual scheme if this takes place at the net asset value of a member’s interest. However, it would serve to discipline the trustees.
Compulsion is far from desirable. It does not engender trust. It lowers the governance control standards of a scheme and exposes members to the possibility of management abuse. The possibility of exit (which includes not joining) by members is a powerful governance tool.
Alone, such fair and competitive pricing is unlikely to prove sufficient to ensure the sustainability of a scheme. In order to avoid questions of time consistency and the related perceptions of inequitable treatment arising, wherever feasible discretion should be avoided; this may be achieved by writing definitive situation-specific rules of management action. These rules must define the interest of a member in the scheme assets, and the manner in which problematic developments will be managed. These are risk-pooling and risk-sharing rules.
Risk-pooling should be an attractive facet of a collective scheme as it lowers the per capita risk faced by members relative to that faced by an individual alone. Several of the responses to the parliamentary work and pensions committee’s inquiry seem to have misunderstood the concept of risk pooling. They believe, erroneously, that investment in a collective mutual fund constitutes risk-pooling. It does not; that is just the acceptance by participants of a common risk and reward profile. By contrast the collective pooling of the disparate life expectancies of scheme members is true risk-pooling as it provides a statistically better-defined outcome, and with that, lowers costs.
There are many ways in which the interest of a member in the collective assets may be defined. In individual DC, the definition is through the acquisition, and subsequent disposal, of units in the fund. This is a one-to-one mapping through those units of contribution to outcome, and is fair in one sense. However, it clearly may result in widely varying outcomes and is incomplete as it leaves unresolved the decumulation problem, the conversion of a capital sum to retirement income.
Moreover, it does nothing to generate any enduring solidarity among scheme members; it will be vulnerable to member runs in troubled times.
There are superior forms of definition of a member’s equitable interest in the assets of the scheme. The traditional form of award of DB pensions is particularly attractive. Here the uniform contribution rate and uniform proportion of salary awarded for a year of service regardless of the age, life expectation or salary level of the member implies different rates of return on contributions are being offered to each member. In other papers and discussions, we have referred to these implicit investment return rates as contractual accrual rates. The scheme’s required rate of return on contributions for a year’s awards is a weighted average of these, and over time a weighted moving average of many years’ awards.
This rate of return is a commitment among members, and enforceable among them, but it is not a commitment by the scheme to deliver the benefits, per se. It serves to define relative interests in the scheme assets, and in this sense is a member’s equitable interest.
One of the interesting properties of this rate is that it is the rate as which the 25% of assets available as a lump sum in DC is equal to the 25% of income available under DB arrangements.
The principal difference between CDC and CDB is that with CDC members may draw the full net asset value of their equitable interest, including those situations where the net asset value exceeds 100% of their equitable interest. Annuitisation by a CDC member would be limited to 100% of their equitable interest, with any excess being taken by drawdown or transfer. By contrast with CDB, the maximum which may be taken as a lifetime pension income is 100% of a member’s equitable interest, with any surplus being retained as orphan assets within the scheme. We will discuss these decumulation arrangements and the risk-sharing around them more fully later.
This simple award device is attractive to both young and old; it is true risk sharing. It operates ex ante, and over the full lifespans of members. When expected returns are high, and necessary contribution rates low for some specified benefit level, this arrangement supports the elderly active member at the expense of the younger. When expected returns are low, and contribution rates high, it is the older members who support younger. Quite apart from the attractions of smoother returns opportunities, the young should expect to grow old, which would tend to compensate for any inherent systematic bias. This is a powerful incentive structure which should encourage younger individuals to join the scheme, helping to ensure its sustainability. It is truly a form of insurance. It also concretises solidarity among members by associating benefits with that.
The equitable interest of a member and the scheme are inherently very smooth. Changes are meaningful as is obvious when their source is considered, Changes to projection assumptions, such as longevity and inflation, have real-world meaning; similarly changes in the equitable interests of members arising from risk management action also have meaning.
A consequence of this smoothness is that the solvency ratio, the level of scheme assets relative to the aggregate equitable interest of the scheme, will tend to approach the volatility of the asset portfolio. It should be recognised that this smoothness arises from the construction of the scheme, it is not some discretionary action performed upon it.
While we could argue for risk management decision metrics based upon the long-term and the cash flow generation of a CDC scheme, we shall consider, here, the more familiar form of current balance sheet solvency. Obviously, the volatility of assets is such that the scheme may from time to time report solvency deficits. It is the presence of a deficit, a shortfall of assets, relative to the aggregate equitable interest which prompts consideration of possible cuts to the current year’s pension payments. The variation rules operate from year to year based upon that year’s solvency position.
In the absence of pension payments, such deficits do not in and of themselves warrant any management intervention, with one notable exception – deficits in the solvency ratio which are persistent and widening are indicative of systematic bias and error in the terms of awards, the discretions and judgement exercised by trustees. This should be corrected when identified by lowering the equitable interest of all. Even though this misestimation may be rooted in inflation or longevity experience, it is best and most simply corrected through adjustment of the scheme’s contractual accrual rate. Subsequent awards should then use the revised estimates for these projections.
The management action, or adjustment mechanism, in all cases is uniform proportional change to a member’s equitable interest.
This contrasts starkly with the method employed in Holland, where it is annual indexation which is cut. This is profoundly inequitable among members. Even pensioners in payment have different expected periods of receipt of their pensions, corresponding to their life expectations, and with that bear different proportions of the loss.
The null position with CDC when the scheme is shown as being currently in deficit is that the full targeted pensions should be paid, unless certain further control rules are breached. When a larger pension than warranted by assets is paid to pensioners, the equitable interests of non-pensioner members are increased in similar proportion. This ensures ongoing fairness among members. The share of the non-pensioner cohort in the scheme’s over equitable interest has increased relative to the pensioners. That is fair in that the pensioner cohort has already received support.
Many deficits may arise from the animal spirits of market prices. The passage of time will tend to resolve these, accordingly there should be a simple forbearance rule, during the operation of which pensions will continue to be paid in full. This rule is that a 10% deficit should be resolved within ten years, or a 20% deficit in five and 50% within two years. Further simple rules may be applied to limit the cumulative support, arising from sequences of deficits within these forbearance periods, that is offered to pensioners.
In particular, such a forbearance rule could, in remote circumstances, result in depletion of the asset portfolio to the point that it might never be able to recover – the so-called death spiral. To avoid this a limitation on the aggregate support available from non-pensioner members is applied. A limitation of support in any year or sequence of years of 10% of the total equitable interest of non-pensioner members has historically ensured that pensions would be paid in full at all times and that no death spiral would have occurred. This result is sensitive to the distribution of membership of the scheme, the dependency ratio between pensioners in payment and non-pensioner members.
This question of a sustainable dependency ratio is important in the context of the scheme offering admission to new members solely for decumulation purposes.
If either or both of these rules is breached, then pensions in payment as well the equitable interests of all non-pensioner members are cut in similar proportions. This deserves emphasis: if pensions in payment are cut so also are the equitable interests of non-pensioner members.
This may be recognised as being a game in which co-operation is rewarded and defection penalised. It enhances the solidarity of scheme members. For example, a new member considering entering the scheme when it is in deficit will be offered the fair value for money terms determined by the trustees and also have the prospect of an immediate uplift of that reflecting the support being offered to current pensioners.
It is absolutely clear that questions of inter-generational or even intra-members unfairness do not arise.
The scheme can offer all of the flexibilities of freedom and choice. Although the equitable interest is defined in terms of a pension income, it is as easily stated as a capital value. Indeed, the capital value and income equivalence of their interests may be reported to members throughout the lifetime of the arrangement. The decumulation process may offer drawdown or its pension income equivalent, and it may do so flexibly throughout the decumulation or pension payment period. While there is a degree of adverse selection possible as the chronically and terminally ill withdraw their capital, this is more than offset by the tendency for individuals to underestimate their own life expectation and withdraw capital sums earlier than they should.
The ability to transfer at any time at net asset value is an extremely powerful demonstration of the scheme’s trustworthiness. There are numerous risk pooling and risk-sharing mechanisms within this basic design, which should serve to enhance trust in and solidarity with the scheme as they bring positive benefits.
A member leaving the scheme would be foregoing these continuing advantages. It is of course possible to introduce further developments. For example, where the tax rules permit, schemes could offer early access to funds for qualifying purposes, that is to say, they may well function as provident funds.
The most important thing to understand with CDC is that it is concerned with improving the DC offering. It is forward-looking.