On Saturday, on Radio 4’s Money Box programme, Hugh Nolan of the Society of Pension Professionals expressed the view that the “ship had sailed” for CDC pensions, and proceeded into the tired and repetitive narrative that it is too late for CDC to resolve the problems of DB pensions. By contrast, Hilary Salt of First Actuarial made the point that CDC is overwhelmingly about correcting the problems with, and improving individual DC.
In light of this exchange, I thought that I should review the Society of Pension Professional’s submission to the parliamentary Work and Pensions Committee’s inquiry into CDC. As that submission is long and consists mainly of the repetition of their response to the 2013 Defined Ambition consultation, I shall limit myself here to their observations, which are new. As with my other submission reviews, the submission text is reproduced verbatim, in black typeface, while my comments are shown in red.
OBSERVATIONS ON COLLECTIVE DEFINED CONTRIBUTION PROVISION
10) Experience in The Netherlands and Denmark shows that collective defined contribution provision in different forms is feasible and can provide more certainty about income in retirement than conventional defined contribution provision, although the Dutch model is currently facing some serious challenges.
As we have noted in many other articles and notes, we do not consider the Dutch or other overseas models to be appropriate for use in the UK. Indeed, they do provide many examples of what not to do.
11) There is, however, no tradition of risk sharing between pension scheme members in the UK
I am not convinced that this is an unqualified truth. In terms of tradition, we might go back to the friendly societies and burial clubs of the 19th century. And the traditional form of award of DB, where the contribution rate and benefits awarded are uniform for members regardless of age, and many other relevant variables, is a form of risk sharing, albeit one which is superseded and obscured by the employer guarantee.
As risk pooling and sharing appear poorly understood in many submissions, I shall take this opportunity to explain the situation.
Firstly, we should recognise that, with individual DC, members face risks which are many, large and uncompensated. Risk-pooling and sharing reduce the absolute amount of risk faced and increase the return outcomes.
The ex-ante risk-sharing embedded in the award process is a valuable form of insurance, which would otherwise be costly to acquire. Indeed, the situation goes beyond this, as both the writing and the acquisition are profitable exercises, and both are contained within the scheme.
A properly designed CDC scheme while offering support among members when needed will also maintain the fairness (equitable interest) for all members. These are prerequisites for a sustainable system. These provide incentives for individual to wish to join such schemes.
For the collective rather than individual solution, I will pray in aid a quotation from the American philosopher, Richard Rorty: “…our maturation has consisted in the gradual realization that, if we can rely on one another, we need not rely on anything else.”
and some of the issues, which would need to be addressed in considering collective defined
contribution provision in a UK context, would be:
(a) It is important in all situations that scheme members understand the nature of any risk they are undertaking, so, if collective defined contribution provision involved members in effect deploying their own capital, to increase certainty on their own entitlements, it would be essential that they understood that that was what they were doing.
I wonder also as to the absolute truth of this assertion. Certainly, members should be aware that the hoped-for income may not materialise if investment returns and mutual support mechanisms are insufficient, but with disclosure of the net asset value of the member’s equitable interest and its pension income equivalent available throughout the life of the scheme, there is little room for surprise. Perhaps the most important thing about risk that members should grasp is that the outcomes in the collective environment are likely to be much better than those faced as individuals. In both situations, individual DC and CDC, members are deploying their “own capital”.
(b) Individuals often indicate that they would welcome more certainty on retirement incomes than conventional defined contribution provision can offer,
It seems to me that what is wanted is rather more predictability than certainty
but they would need to understand that
(a) any certainty comes with a cost and
This is not actually true. Variability of outcomes may be reduced, or equivalently the level of certainty increased by some quite simple actions such as risk-pooling.
(b) the consequence of more certainty on the downside might be less scope for benefitting from the upside.
This is true as written, but increasing certainty does not have to be costly, though it often is, for example, in risk transfer arrangements.
(c) The introduction of the Freedom and Choice flexibilities increases the incentive to members to remove money from funds when returns are good, leaving the remaining members more exposed to downturns.
Exercise of the Freedom and Choice options at the net asset value of a member’s equitable interest does not leave “the remaining members more exposed to downturns”.
Exercise of these options would have a marginal effect on the risk-pooling benefits associated with longevity, but the aggregate direction of this is scheme specific, given the propensity of individuals to underestimate their own life expectations.
Freedom and Choice runs counter to any collective approach based on smoothing investment volatility, although its impact could be reduced by a scheme design, which prevented transfers out, once a pension was in payment.
CDC as envisioned does not involve any smoothing operations; the smoothness evident is a product or attribute of the scheme design and structure. It is not necessary to restrict transfers out when a pension is in payment, or drawdown. Indeed, given that this option is always available, it is likely, somewhat counter-intuitively, to increase both trust in the scheme and the persistence of membership.
Also, if members had the option to transfer out, this would restrict the investment strategy to one which provided sufficient liquidity for the possibility of transfers.
This would only be true if the scheme was unable to borrow.
It should be recognised that transfers out involve the member transferring forgoing the beneficial risk-pooling and sharing arrangements of CDC.
(d) With profits funds were a previous attempt at providing some smoothing of outcomes, and something similar might form part of a collective defined contribution approach. No, there is no smoothing introduced.
The failure of with profits was due primarily to lack of transparency if governance on the costs and charges associated with achieving smoothing (I do not understand this text); therefore transparency would have to be at the forefront of collective defined contribution provision.
One of the major problems of with-profits was the discretionary nature of smoothing and bonus awards, these invite problems of time inconsistency. To the greatest extent possible discretions in CDC should be avoided and substituted by explicit scheme rules. However, the point on transparency is valid, and has already been answered above.
(e) Any approach to collective defined contribution provision, which involved a significant risk of a reduction in benefits once in payment, could be unacceptable to some members,
Membership of a CDC scheme would be voluntary, individuals may transfer out at any time at the net asset value of their equitable interest. By continuing membership, individuals are accepting the possibility of cuts.
but would be a necessary safety valve for the scheme, based on Dutch experience.
Cuts may in some circumstances be necessary, but the Dutch experience is one of unwarranted excessive cuts brought about by inappropriate scheme design and regulation. However, under income drawdown, members do opt to give up the certainty of an annuity in exchange for a higher initial income, with a risk that they may need to reduce the income they draw, if returns are not as good as expected.
(f) Members uncomfortable with the risk of a reduction in benefits in payment would need the reassurance of a right to transfer out and convert their collective provision into a traditional defined contribution fund (with ability to, for example, buy an annuity at retirement). This right to transfer exists in my vision of CDC.
(g) The ability to pay fluctuating benefits would, in any case, require more flexibility than currently exists in the pension taxation regime (for benefits wider than “other money purchase” where flexible drawdown is already possible).
The decumulation processes envisaged all fit within existing taxation rules.
(h) Accounting for pensions under IAS19 or other accounting standards is an important consideration for many employers. For a collective defined contribution scheme to be attractive to many employers, they would need to be able to account for them without a balance sheet liability, in the same way as for a defined contribution scheme. Under current accounting standards, this could be achieved if the wording of the regulations and/or scheme rules ensured that there was no employer liability to make good a deficit.
It is absolutely clear that there is no recourse to any sponsor employer, if such exists. This is a DC scheme and should be accounted for as such. There are not even “constructive” liabilities created.
(i) A significant matter to consider for any employer contemplating involvement with collectivedefined contribution provision would be any risk that it could go the same way as defined benefit, i.e. employers establish new schemes in good faith, only to have the benefits theyintended to provide at the outset modified or gold plated by future governments, e.g. theimposition of increases to pensions in payment.
This is a much-discussed possibility. I wonder if it is actually feasible. Increasing the benefits payable by a scheme may be government-imposed but it is the assets of the scheme which determine what will be paid. The benefits are not “promised” by the employer but by the scheme.
However, the Pension Schemes Act 2015 includes provision for defined contribution plus as avariety of defined contribution scheme, so any modification or gold plating of such schemes would potentially also affect defined contribution provision generally.
With schemes operating as member mutuals, such interventions are self-defeating and would likely be electorally costly.
In any case, if collective defined contribution provision was through a master trust or other provider, with no single sponsoring employer available to meet any increased costs arising from government intervention, such intervention would be less straightforward.
(j) Any conversion of existing defined benefit to collective defined contribution provision, however carefully handled, would probably lead to some members losing out and it is doubtfulwhether there is willingness in this country to accept this. So, we would expect that any move to collective defined contribution would be in respect of future service.
The ship may have sailed for the DB lite version of CDC, as a replacement for existing DB. Certainly that is a much-shrunken market and the conversion is fraught with difficulties. However, CDC as an enhancement to individual DC is a ship coming home, laden with attractive goodies. We should give it safe harbour.