The absence of any guarantee supporting the promises of a CDC pension scheme makes the question of financial guarantees topical. The most important point to understand is that a guarantee does not ensure certainty of performance. It may be: “an undertaking to answer for the payment or performance of another person’s debt or obligation in the event of a default by the person primarily responsible for it.”, but that does not imply certainty of payment or performance.
That will be limited by the guarantor’s resources, which may prove inadequate in the specific circumstances. It does though reduce the likelihood of an enduring default.
Occupational pensions may be guaranteed is a number of ways. The traditional funded DB scheme has the resources of its funding and recourse to the sponsor, a guarantee, to support and discharge its obligations. This scheme may call for the infusion of further assets from the sponsor.
In some countries, defined benefit pensions are unfunded, the support is entirely in the form of guarantees, and pensions are paid by the sponsor employer. The contributions and investment assets are retained within the sponsor company, and the obligations take the form of book reserves in the corporate accounts. Such arrangements are usually further supported by indemnity insurance policies.
The position when a pension promise is written by an insurance company is slightly different. The promise is supported by all of the resources of the insurer, including those assets which would otherwise belong to other claimholders, notably shareholders. However, in common with the earlier corporate example, these resources are finite in amount.
CDC differs in that its promises, its obligations, are expressly limited to the available resources of the asset portfolio and promised benefits may be cut if they are not covered by investment assets. In ordinary circumstances, the existence of a solvency deficit would require limitation of current pension payments to that proportion covered by funding, unless the trustees had reason to believe that the funding would improve during the ongoing life of the scheme.
It is doubtful that speculation about better financial market performance would constitute grounds for reasonable belief.
CDC schemes can alleviate this solvency problem by risk-sharing among the different classes of member. This would work by allowing the payment of full pensions, up to some pre-determined limit defined in terms of non-pensioner members’ interests in the scheme.
For sustainability, it is important to do this in a manner which maintains the equitable balance between all members, though trivial to achieve. It should be recognised that this is risk-sharing, not cross-subsidy. It provides the added assurance that is provided by the call on additional resources in former arrangement’s guarantees while not providing any new funding.
While this may be surprising at first sight, it should be recognised that the guarantees of traditional DB and insurance are costly. When fairly priced those costs should be similar to the funding inflows under exercise of the guarantees. In practice, the regulation of these guarantees makes them far more costly than their fair value. These are not costs borne by the CDC scheme.