The advent of CDC will offer an opportunity to introduce forms and techniques for risk management which are intrinsically more efficient than those currently advocated by the Pension Regulator and which are consistent with the true duties and obligations of trustees.
The issue of concern is the sufficiency of scheme assets to meet the “promises” made to members. The value of these promises depends upon the contribution made in respect of an award and the projected amounts of pensions payable, and the amount of time which has passed since the award was made.
Put another way, the amount of the contribution made and the projected pension payments define a rate of investment return on the contribution implicit in an award. We refer to this rate as the contractual accrual rate (CAR). It is the compounding of the contribution at this rate which determines the equitable interest of the scheme member at any point in time. This is illustrated in figure 1, below.
In this illustration, mortality is deterministic. It is, of course, trivial to apply a mortality table which would change the shape of the decumulation phase but otherwise add nothing. All projected pension cash flows and their input parameters are best estimates.
This contrasts with current DB practice where the emphasis is upon prudence in technical provision derivation. However, CDC differs from DB or other financial contracts in two important ways. The first is that there are no external resources for the scheme to call upon – the asset fund is all there is. The second is that there is only one class of participant, a member, for whom their claims upon scheme assets all have similar priority.
In banking, the claims of depositors are senior to those of shareholders, in insurance it is policy-holders rather than depositors. In essence the senior class has a call upon the resources attributable to shareholders. With DB the call is explicit and upon the sponsor. The overestimation of liabilities in a prudent technical provision context should serve merely to limit the frequency or magnitude of claims upon the sponsor employer. It is much abused in current practice.
It is pointless to partition the assets of a CDC scheme in any manner, though it is done in the Netherlands with their risk buffers; it is no different from moving money from one pocket to another. Total wealth is unchanged, though some may now ne less accessible. It does not enhance the security of the “promise” to members. However, it is possible to enhance member security by exploiting another property of pensions, their time dimension.
Balance sheet insolvency is not a binding condition. Even companies may continue to trade while balance sheet insolvent if the directors believe that such trading will rectify the insufficiency. It is cash flow delinquency which is usually binding; the non-payment of a sum now due constitutes an event of default in almost all circumstances. To an extent, it may be argued that the period allowed by the Pensions Regulator over which deficit repair contributions may be made is recognition of this.
Even schemes which are weakly funded, that is have substantial deficits, do have some assets, which may be used to pay current pensions. Cash flow insolvency is very remote in time. However, discharge of a current pension payment obligation is intrinsically inequitable to non-pensioner members of a scheme if that payment is made at a time when the scheme is in balance sheet deficit. All scheme members have claims upon the scheme, their equitable interests, but it is the net asset value of those claims which determines their quantum at any point in time. If the scheme pays pensioners in full, it is overpaying them relative to other members.
However, scheme risk-sharing rules may overcome these difficulties. The most obvious is to allow forbearance time limits, associated with an absolute amount of scheme equitable interests which may be committed to support of current pensions. In this, the scheme rules are substituting for the buffers and capital adequacy regimes, and indeed prudential valuation, seen elsewhere. The key to sustainability for such rules is that they should maintain the equitable balance among members.
A simple illustration is appropriate. Suppose we have a scheme which has pensions payment amounting to 5% of the total equitable interests of members, but that this is only covered as to 80% by scheme assets. Let us also suppose that the scheme membership is 60% non-pensioner and 40% pensioner. Then the support afforded to pensioners amounts to 1%.
To maintain equitable balance among members, it is necessary to increase the equitable interest of non-members in similar proportion.
The effect of intra-member support is illustrated, for pedagogic purposes, in figure 2. This figure shows a scheme consisting of just three members who at time of the single award shown were aged 25, 45 and 64. We then consider the situation if the pension payment due (to the former 64 YO) in the fifteenth year is only covered by assets to the extent of 50%. Payment of the full pension in this case involves support as to 2.96% of the overall scheme equitable interest (3.7% scheme assets).
The equitable interest of the pensioner member is unchanged before and after support, the equitable interests coincide everywhere. The equitable interests of the non-pensioner members, and their pensions subsequently increase.
The amount of support needs to be supplemented by rules as to the term of forbearance. These may take the form of simple rules such as a 10% deficit must be recovered with ten years, a 20% deficit in five years and a 50% deficit in two years. Continuing deficits would trigger cuts to the equitable interests of all members, a rebalancing of the scheme.
There are many nuances which might be discussed but that would distract from the central thrust of this article, which is that these rules operate in the here and now; they are objective and operate only on the current pensions payable. Next year’s possible deficit or surplus or next year’s pensions are not considered.
This contrasts starkly with interventions used widely in the Netherlands and proposed by some here in the UK, with the prime example being variation in indexation. These interventions are invariably inequitable in their operation on the relative interests of members. In the case cite above, the quid pro quo for support of the pension payment is an increase in the relative claim of non-members on scheme assets.
It is perhaps surprising that solitary intervention today may serve with respect long-term risk management, but it is, in fact, highly efficient. The statistical treatments of risk suffer from the disadvantage that they may include, and generate provisions for, many events which may happen but won’t actually eventuate.
The statistical approaches are also subject to the criticism that they disregard uncertainty dealing only with circumstances for which we may assign probabilities. Simply put, the method proposed eliminates the false positives of statistical testing, and their associated costs.
The amount of unutilised support available constitutes a new potential risk metric: it can be used to estimate the length of time during which pension payments are not likely to be cut. This also feeds into the investment management mandate. The contractual accrual rate provides asset managers with a target return to be achieved, and the unutilised support available provides an estimate of the term over which, on average, it is desirable to achieve that rate.