This is my (Con Keating’s) review of and commentary upon the submission made in response to the committee’s call for evidence. It follows my precedent of verbatim quotation in black typeface with my commentary in red.
There is precious little evidence contained within it. Much of the submission is concerned with attributing spurious motivations and intents on the promoters of CDC. There are then extensive attempts at demolition of these bogus motivations. It exhibits the peculiar phenomenon that I have previously described as recrudescent Ralfe syndrome. Less than ten percent of this submission is factually accurate or relevant.
My conclusions are:
1 The underlying economics of “CDC” pensions is flawed
As we will show below, it is this submission which is flawed.
1a The claim that average CDC pensions are 30 to 40 per cent higher than
DC, is faulty economics, based on the idea that investment risk declines
over time, so there is a (sic) an equity “free lunch” for long term investors.
It is based on no such idea. It is based, in large part, on the longer term over which investments will be held. There are further sources of higher returns from CDC than traditional DC, notably the objective function of the fund.
1b The higher expected return of equities is not a “free lunch” or a “loyalty
bonus” for long-term investors – it is just the reward for the risk of
holding equities.
This is an interesting theoretical assertion; unfortunately, one for which there is no empirical support. Equities may be held collectively in a manner unavailable to the individual, whose pre-occupation is with annuity purchase or capital decumulation as income.
1c If holding equities for the long run really does generate higher average
returns, with negligible risk, why don’t banks provide guaranteed equity
outperformance, for a modest fee reflecting the “modest” risk?
No-one has claimed negligible risk. As for his question, the reason is simple: this is not the business of banking, just as the provision of fish and chips is not the business of banking.
1d A CDC plan can transfer investment risk from one member or generation
to another, but is cannot reduce it. If one CDC member takes less equity
risk, another member is taking more risk.
This is ridiculous. It is fallacious; twice over. Classic recrudescent Ralfe syndrome. A CDC fund is a common fund to which all members are exposed. All are taking the same investment risk at any point in time.
2 Lobbyists should explain the precise nuts-and-bolts of CDC
This is again nonsensical. It is sufficient to describe the functional relationships and recognise that within those there are many details which may be handled in different ways. The variety of such designs is a hallmark of the potential flexibility of the CDC approach.
2a Although CDC has been discussed for several years it is not a clearly
defined-term, but means all-things-to-all-people. No one has provided
precise nuts-and-bolts of how any CDC structure would work in practice.
There are in fact a number of models which have been described in detail and rather a lot which exist in practice outside of the UK.
2b Because CDC is about “sharing” or transferring risk from one individual, or
one generation, to another, it is crucial this risk transfer mechanism is
scrupulously fair and transparent, so those bearing the risk also receive
the reward.
This is the first point of agreement; but hardly one which is new to the world of collective and co-operative institutions. It was no accident that the Rochdale pioneers named themselves: the Rochdale Society of Equitable Pioneers
2c CDC “intergenerational risk sharing” seems to requires successive
generations of new members, each able to pay the previous generation, if
necessary – suspiciously like a Ponzi scheme.
He seems to have invented an “intergenerational risk sharing”. CDC schemes are member mutual institutions, collective co-operatives. It is a funded pension arrangement; there is no reliance upon the contributions of later members to discharge current pensions payments. Clearly, he does understand what constitutes a Ponzi scheme.
3 Lobbyists should explain how CDC would be regulated
It is in the name – as collective defined contribution. They are just DC schemes organised collectively rather than individually. How foolish we were to believe that people would read the name as being descriptive.
3.1 Robust and transparent regulation of a new and untested savings vehicle
is crucial to make sure CDC plans do what they “say-on-the-tin”.
There is no new savings vehicle; this is a collective investment fund. The last time I looked there were tens of thousands of them. What may be new is the way in which members allocate among themselves their equitable interests in the fund, and that is a matter for members, not regulators.
3.2 Rather than a “DIY” valuation left to trustees and actuaries, CDC plans
should be required to publish a quarterly funding statement showing the
value of “target pensions”, on a prescribed bond basis, and taking asset
allocation into account.
This is confused to the point of incoherence. These are DC arrangements – a member may expect to have available, in near real-time, the net asset value of his or her interest and the income equivalence of that under scheme rules. Neither the fund’s asset allocation nor a “prescribed bond basis” whatever that might be are relevant.
3.3 There must also be strict rules on dealing with a shortfall by cutting
“target pensions”, including pensions in payment.
No. Cutting pensions in payment is the last resort. It takes place only when risk-sharing possibilities have been exhausted.
4 Dutch CDC experience is not encouraging for the UK
I will not comment here on the Dutch experience as I have on many occasions cautioned that it is a better guide of what not to do than template for a UK CDC system.
4a Dutch CDC plans were set up as DB, but when the Courts ruled that
employers had no legal liability for deficit contributions, things were
fudged and “DB” pensions morphed into CDC.
4b Although Dutch CDC plans are tightly regulated there has still been a
cross subsidy in recent years from younger employed members to older
retired members. Younger unhappy members cannot vote with their feet
by leaving – workplace pensions are compulsory – and there have even
been street protests.
4c The Netherlands is moving away from collective CDC pensions, with many
Dutch experts recommending individual DC accounts and individual asset
allocation, with individual property rights.
This arises from the intrinsic flaws built into the Dutch version of the CDC model. It is always dangerous to shift conclusions from the specific to the general.
“CDC” seems to offer an easy solution to a difficult problem, but is flawed in
theory and practice.
An assertion lacking any supporting evidence or substantial argument.
Rather than wasting time trying to develop CDC we should improve the
existing large-scale DC pensions the UK already has.
This demonstrates a truly bucolic ignorance. CDC schemes are improvements on existing DC arrangement.
We have removed a section of puffery laying claim to expertise in pensions.
1 Introduction
1.1 In recent years some UK investment experts have been pushing for the
introduction of so-called “CDC” pensions, like the Netherlands. These aim
to “bridge-the-gap” between traditional defined benefit pensions – with an
employer guaranteeing a pension for life based on salary and years of
service – and defined contribution pensions, with each individual taking
their own investment and longevity risk, and with no guaranteed pension.
1.2 Unlike DB or “Defined Ambition” pensions, which have also been
discussed, a CDC pension would have no employer guarantee. Rather it
would set a “target pension”, to be raised or lowered depending on
changes in the fund’s overall level of funding – assets versus liabilities –
including changes in longevity. Assets would be held collectively, on
behalf of all members, rather than individual accounts, like DC.
A member’s equitable interest is well defined, and with that their claim on scheme assets at any point in time.
1.3 CDC lobbyists claim this “middle-way” can offer pensions 30 to 40 per
cent higher on average than DC, with fluctuating asset values smoothed
through some form of “intergenerational” risk sharing.
CDC is no “middle way”. It is a response to the incompleteness of DC as a pension. There is no “form of “intergenerational” risk-sharing, though there is both risk pooling and sharing among all members at any point in time.
1.4 My comments cover:
– Where does the extra return of 30 to 40 per cent v DC come from?
– What are the precise nuts-and-bolts to ensure CDC fairness?
– What would be the precise regulation of CDC?
– What is happening to CDC in the Netherlands?
1.5 I then address the specific questions raised by the WPSC
2 The underlying economics of “CDC” pensions is flawed
2.1 A CDC plan could certainly have lower transaction costs than the most
expensive DC – economies of scale, auto-enrolment and passive-only
investment costs – compounding over years to generate a higher pension.
But existing arrangements, such as NEST can already provide lower costs.
The objective function of a traditional collective fund is to maximise asset values at all times. The objective function of a CDC fund differs: it is to equal or surpass the implicit contractual accrual rate associated with the target pensions awarded, on average. The “on average” relaxation is admitted by the risk-pooling and sharing among all members. The term is longer encompassing the period spent in retirement.
2.2 Lobbyists argue the higher CDC pension really comes from
“intergenerational risk sharing” with savings paid into a collective fund,
not individual accounts.
We do not. It is the longer investment term which accounts for a significant proportion of the excess performance.
Because a CDC plan has a longer time horizon than any single individual,
it can take more investment risk – a higher proportion of equities, and a
lower proportion of inflation-protected bonds – to generate higher
investment returns and a bigger pension.
This is simply not being said. It is an invention of the author – a bogus claim. If anything CDC funds will tend to have lower risk than traditional DC fund.
2.3 This claim is based on standard historical modelling of the volatility of
past equity returns, showing the probability that equities will earn less
than the risk-free rate bond rate decreases with time – the familiar
argument encouraging long-term pension savers to hold equities.
Since a collective CDC plan has a longer time horizon than any single
individual, this would allow it to take more equity risk, to generate higher
average returns, and a higher pension.
Neither of these claims is in fact being made.
2.4 This argument assumes that if the time horizon is long enough, equities
will always outperform bonds – so a collective CDC pension, with new
members joining, can absorb the risk of holding equities in perpetuity. No such assumption is being made. Bogus analysis heaped upon the bogus critique.
The heart of the CDC argument is the belief that there is an equity “free
lunch” for long term investors.
This is a non-sequitur.
2.5 But the higher expected return of equities over inflation-protected
government bonds is not a “free lunch” or a “loyalty bonus” for long-term
investors, but is just the reward for the risk of holding equities.
This is a man who would buy inflation protected bonds – when their price assures us of loss of real purchasing power – how is that consistent with any common-sense notion of investment.
2.6 The proper measure of long-term equity risk is not the volatility of past
equity returns; rather it is the cost of buying insurance against
underperformance versus the risk-free return – a “put” option on a stock
market index. If risk really does reduce over time, the cost of equity put
options should fall the longer the option period.
We are doing well here – he has introduced a risk-free rate (a glorious theoretical abstraction frequently seen alongside golden unicorns) and a stock market index. The assertion is that the supporters of CDC argue that risk reduces over time, but we have never said that. It is another bogus construction.
2.7 In reality, the cost increases the longer the option period, reflecting
increasing, not decreasing risk. The theoretical price based on a standard
option pricing model, and actual prices charged by banks are about 25 per
cent for 10 years and 30 per cent for 20 years.
2.8 The argument from option pricing “insurance” was first made by Prof Zvi
Bodie in 19941, and has been discussed many times since, in both the
academic and investing literature.
2.9 If holding equities for the long run does lead to higher average returns,
with negligible risk, why don’t investment banks or insurance companies
provide guaranteed equity outperformance for a modest fee reflecting the
(supposedly) modest risk?
If the reader really wants to understand the relationship between safe and risky assets, I would recommend a 2018 US Federal Reserve publication: The Rate of Return on Everything, 1870 – 2015. It does not support Mr Ralfe’s contentions.
2.10 A collective CDC pension could transfer investment risk from one member
to another or from one generation to another, but it cannot reduce the
overall risk of holding equities. If one CDC member takes less equity risk,
this must mean another member is taking more risk.
This shows another fundamental misunderstanding of the properties of risk as well as the attributes of collective funds.
3 Lobbyists should explain the precise nuts-and-bolts of CDC
3.1 Although CDC has been discussed in the UK for several years it is a long
way from being a defined-term. This is a recrudescence see my earlier comments.
There may be different CDC structures, but so far no one has provided
precise nuts-and-bolts of how any would work in practice.
There are many examples around the world and there have been a number of different model designs proposed but as was noted earlier, it is unnecessary.
3.2 Because CDC is about “sharing” or transferring risk from one individual, or
one generation, to another, it is crucial that this risk transfer mechanism
is scrupulously fair and transparent, so those bearing risk also receive the
reward. The mechanism must avoid one group getting a reward, without
bearing and risk, at the expense of another group, bearing the risk, with
no reward.
This is simply saying that the scheme must be equitable in the manner in which members are treated. It is one of the very few things in this submission with which I agree.
3.3 In particular, if the risk transfer rules allowed contributions from younger
members to subsidise those already drawing a pension, younger members
would simply leave or not join in the first place, and the CDC plan would
collapse.
Here there is a fundamental misunderstanding. Contributions made for new awards should never be used to repair prior deficits, nor should they be used to distribute surpluses. In point of fact, younger members would find a scheme in deficit particularly attractive to join since they would receive fair value for the contribution and recompense for the support they are providing to pensioners in payment. Incidentally, a scheme which attracts no new members does not collapse; it runs off slowly and smoothly.
3.4 Each successive generation might be prepared to sign up to
“intergenerational risk sharing” if it knew the next generation would, in
turn, also sign up – each generation running the risk of paying an older
generation, in exchange for the possibility of receiving a payment from a
younger generation.
This is a valid concern for unfunded pension systems such as those operated by states, but it is irrelevant in the context of CDC where the risk-pooling and risk-sharing are among members. No private body can bind some future independent person.
3.5 But the first generation in a CDC plan gets a free-ride. It can transfer risk
to the second generation without having taken risk on behalf of an earlier
generation.
Again, the risk pooling and sharing in CDC schemes is among members. The author of this submission confuses risk transfer and risk sharing. There are no free-riding possibilities.
3.6 Equally the last generation in a CDC plan faces the risk of paying the
penultimate generation, but, by definition, it cannot receive a payment
from a younger generation. End-to-end the first generation gains at the
expense of the last.
This is simply not true of a funded arrangement. Frankly the analysis here is infantile.
3.7 CDC intergenerational risk sharing only works with new generations of
members, each able to pay the previous generation. So from day one CDC
looks like a Ponzi scheme, which no one would want to join.
The members of a scheme make contributions into the scheme, which pay for their own pensions when combined with investment returns. The risk sharing among members allows the excesses of the market price variability of the asset portfolio to be absorbed and recovered equitably. There is no Ponzi element to this.
4 Lobbyists should explain how CDC would be regulated
It really is in the name. These are DC schemes for which we have perfectly adequate existing regulation. They are collective, a term which is already adequately defined in the Pensions Schemes Act 2015.
4.1 Like any new savings product CDC regulation must be transparent and
robust to win public confidence, and to avoid storing-up future problems.
Dutch CDC plans – recommended as a model for the UK – operate under
strict funding rules.
Dutch schemes have not been recommended as a model for the UK by anyone. Their funding rules are just one of many ways in which they are inappropriate – those rules create excessive and unwarranted uncertainty with respect to pension payments, and operate inequitably among members.
This is not a new savings product, rather it is a well-established form of saving. The only element which is new is the way in which members define their interests in the fund, which differs from the unitised claim of traditional collective funds. It is not as if other methods of defining claims have not been known in the past. A tontine is a collective fund, where the members’ interests are all subordinated to the last person standing.
4.2 Regulation is especially important because, unlike individual DC pots, CDC
members do not have clearly defined property rights over the CDC assets.
This is simply untrue. Members may remove the net asset value of their interest at any time, at their sole discretion.
4.3 CDC regulation would require strict and transparent solvency rules, with
the ability to cut pensions in payment, and, even claw back pensions
already paid, if solvency deteriorated due to poor investment performance
or increased longevity forecasts.
CDC schemes should consider cutting pensions in payment if the scheme assets are less than the total aggregated member interests. But before doing that the scheme’s risk-pooling and sharing rules should operate. It is only when those options are exhausted that cuts should be applied, and then they are applied to all members. As these rules are a matter of agreement among members, which substitute for risk buffers, there is no case for their regulation. There is no potential for wider harm to the community.
4.4 Although it is crucial the 2015 CDC Bill says nothing specific about
regulation. In particular, CDC trustees, advised by actuaries, are left to
decide for themselves how target pensions for all members should be
valued, so overall funding can be measured against the market value of
assets.
Target pensions are soft promises made to members. Implicit in those promises are rates of return on members’ contribution investments. This contractual accrual rate, the target rate is the valid objective for investment returns and comparison of the capital value of those claims under those terms with the asset value of the fund is an indicator of the progress to the fund towards meeting those pension objectives. Members will have available to them in near real-time both the capital value and its pension income equivalent.
4.5 This “DIY” approach means there is no objective and consistent
benchmark for CDC members to judge the likelihood of their target
pensions being paid. “Trust me, I’m an actuary” is not good enough as the
basis for a wholly new and untested type of pension.
As described above, there is a consistent and objective method of judging, Indeed, if the net asset value of a member’s interest is less than 100%,say 80%, it is clear that the pension which may be affordably paid is 80% of that “promised”. Of course, the risk-sharing rules will serve to improve on this outcome, should that deficit prevail at the time of pension payment.
4.6 CDC plans should have to publish a quarterly funding statement showing
the value of “target pensions”, on a prescribed bond basis. There must
also be strict rules on dealing with a shortfall by cutting “target pensions”,
including pensions in payment.
This is nonsensical. The author wishes to introduce a meaningless and irrelevant counterfactual into the valuation process ( the ”prescribed bond basis”). See my earlier comments on the point in time at which cuts become necessary.
4.7 The obvious benchmark for valuing “target pensions” is the AA corporate
bond rate, required by IAS19 corporate accounting for DB pensions. To
ensure consistency across different CDC plans the Pensions Regulator
should post the required AA rate, the inflation rate and longevity
assumptions each quarter.
This is a specific counterfactual, and specifically wrong for the valuation of schemes. As CDC schemes may have very different risk pooling and sharing arrangements, it is inappropriate to attempt any common method of valuation.
4.8 A quarterly funding statement would be just a snap shot, which ignores
asset mix – two CDC plans may both be 100 per cent funded, but the
funding position for the scheme with a high proportion of equities versus
long dated bonds will be much more volatile.
It is not in general true that bond portfolios are less volatile than equity. There are many periods, including sustained sequences where fixed income securities have proved more volatile. See the earlier referenced Federal Reserve paper, or any of the rigorous long-term studies of investment performance.
4.9 To deal with this funding volatility, CDC plan should also be required to
“stress test” their assets by applying a “haircut”, which could be that laid
down by the PPF in calculating its annual levy.
This is nonsensical. It is an attempt to import a technique which is appropriate in the situation where there is an external agency upon which there may be reliance and recourse, but wholly inappropriate in the case of a risk-pooling and risk-sharing member mutual. It is singularly inappropriate in a multi-period context; it will result in attempts to provide for risks, when one of the few things that we know about risk is that many more things may happen than will.
5 Dutch CDC experience is not encouraging for the UK
5.1 Although CDC lobbyists point to the Netherlands as a model for the UK,
the Dutch context is very different, and the experience is not
encouraging.
Dutch CDC plans were not originally set up as CDC. Rather they were set
up as DB pensions, with the sponsoring employer committed to making
deficit contributions, but this was challenged in the Dutch Courts which
decided companies had no legal liability for deficit contributions.
In response to this legal ruling this issue was fudged with “DB” plans
transmogrifying into CDC.
A very small number of Dutch schemes were set up as CDC. They have not experienced any difficulty other than situations arising from the way in which they are (inappropriately) regulated.
5.2 Workplace pensions are compulsory in the Netherlands, so CDC plans
have a continuous stream of new members, unlike the UK where pension
fund membership is voluntary.
Although Dutch CDC plans are very tightly regulated there has still been a
cross subsidy from younger employed members to older retired members.
Younger unhappy members cannot vote with their feet by leaving their
CDC plans, and there have even been street protests.
As we have said on many occasions the Dutch system is a better indicator of what not to do rather than being a system we should import to the UK.
5.3 The Netherlands is moving away from collective CDC pensions, with many
Dutch experts recommending individual DC accounts and individual asset
allocation, with individual property rights, but retaining compulsory
membership.
Compulsory membership is neither necessary nor desirable for UK CDC.
6 Specific questions asked by the WPSC
6.1 Would CDC deliver tangible benefits to savers compared with other
models?
Although the claim that CDC can deliver pensions 30 to 40 per cent higher
than DC sounds attractive, as explained in section 2, this claim is based
on faulty economics.
Because of this flaw, I do not believe CDC can deliver any tangible
benefits versus DC.
The flaws in the author’s critique were discussed earlier. They invalid his conclusion.
6.2 How would a continental-style collective approach work alongside
individual freedom and choice?
The underlying philosophies of CDC and “freedom and choice” certainly
pull in opposite directions
They do not. Freedom and choice and freely available transfers are available within CDC arrangements where they are a very powerful governance mechanism – exit. They also serve to offer comfort and confidence to members – if I may remove my assets at any time, my risk exposure may be limited or terminated at any time of my choosing.
It may be possible for someone to be in a CDC plan up to the point of
starting to draw a pension, and then transfer all her pension into a SIPP,
and drawdown from this.
Yes – and they may operate drawdown within the CDC scheme, while maintaining the benefits of risk-pooling and sharing.
6.3 Does this risk creating extra complexity and confusion? Would savers
understand and trust the income ‘ambition’ offered by CDC?
CDC would involve extra complexity and confusion which could be
managed properly if the overall advantages were obvious. But since I
believe CDC is a “con” based on faulty economics, then there is no
justification for investing this time and effort.
As had been shown at many earlier points, it is this author’s economics which are faulty.
6.4 Could seriously underfunded DB pension schemes be resolved by
changing their pension contract to CDC, along Dutch lines?
The Dutch Courts ruled that the underlying legal framework of Dutch “DB”
pensions, which were then changed to CDC, did not require employers to
make deficit contributions, so is fundamentally different to UK law.
This means such conversion would be illegal in the UK.
More than that it would be a transfer from pension scheme members to
shareholders and other creditors.
There is no doubt that the law could be changed to allow such resolutions under UK law. It can already be done with informed member consent. Indeed, resolution at insolvency through the PPF is resolution through a CDC scheme, albeit one which is very poorly designed. The complexity of that is obvious for all to see. The open question is not can it be done but should it be. My answer to that would be no. But for more detail on the rationale for that response, see my response to the DWP DB Green Paper.
6.5 How would this be regulated and how would the loss of DB pension
promises to scheme members be addressed?
Not applicable. See 6.4.
6.6 How would CDCs be regulated?
See section 4.
3.4 Is there appetite among employers and the UK pension industry to deliver
CDC?
I have had discussions with various companies about CDC. None of them
support it, and see it as moving back to DB from DC. One FD in particular
is concerned that the company might have some “moral obligation” to
support its former employees if a CDC went wrong.
Given the author’s degree of comprehension, or rather lack of, this is not a surprising result. It is absolutely clear that there is no obligation on any company to support a scheme. No legal, moral or other liability.
3.7 Would CDC funds have a clearer view towards investing for the long term?
No. See section 2.
Here in the best tradition of this submission, the author is again wrong.
February 2018
This appears to have been written after the call for evidence closed.
