Keating on Ralfe, CDC and morality

Last week’s Corporate Advisor’s Pensions Summit featured a debate on the merits of CDC pensions. Johan Ralfe presented the “case” against the introduction of CDC. In the main, with all the showmanship of Barnum and Bailey, this resurrected old and long-rebutted criticisms. His “magic beans” made yet another appearance. The offer of a line by line response was declined during the debate, a situation this blog will correct. The “case” such as it is, is a collection of errors of analysis and logic, and their repetition, despite frequent refutation and disproof, can only be considered a case of wilful ignorance.

The principal assertion made was that CDC is a game of pass the risk parcel; that no-one will join as they risk being the last person in the scheme. This is scaremongering. It ignores the fact that this is the position of all scheme members under traditional DC; they are permanently alone. It would be a very strange world in which members declined a remote possibility of facing difficult choices for one with certainty of those problems.

This was expanded to an outright untruth: “end to end first cohort benefits at expense of last cohort”. The risk-sharing rules within CDC are designed to, and will ensure equity, fairness among all members at all times; these are mutual support mechanisms, not subsidies. No intergenerational transfers of risk or funds occurs. We describe one set of such rules later.

These risk-sharing rules can even ensure that overgenerous awards, which may arise from trustee judgement and discretion in this process, are eliminated early.

In response to the rhetorical question: “How is equity risk premium shared?”, this “end to end” fabrication was followed by the even more bizarre:

“The current generation take the premium …; The next generation take the risk”

The equity risk premium, when earned, is captured in the performance of the asset portfolio, and in the current members’ equitable interests in that. There is no separation in time of the risk and reward, nor can there be.

The argument proceeded to develop a novel, but incorrect, theory of risk: “Can transfer risk from one person to another or one cohort (sic), but can’t make it disappear” This is some imagined law of conservation of risk; but, in general, risk is not immutable. Those risks of our own creation can certainly be eliminated by our own corrective actions, and there is much about financial markets which is of our own creation. We were then treated to a complete non-sequitur: “If risk did reduce with time so those with long horizon could take more risk, no need for CDC”. The higher returns expected from CDC asset portfolios arise not from some excess return associated with long versus short term investment, but from the fact that the funds are invested for a longer period of time, over both the accumulation and decumulation phases. Indeed, for any arbitrary return, that expected from the average decumulation phase exceeds that from the accumulation. This answers another of the questions posed: “where does this extra juice come from? Investment for a longer time. The extra return has been a feature of the findings of all academic and professional simulations, and there have been at least eight studies of CDC around the world.

The juxtaposition of factual inaccuracy and irrelevancies is quite remarkable. Take the sequence:

Longevity pooling?

Maybe, but not spelled out

Can this be achieved more easily?


Longevity pooling is a feature of all CDC designs. Life-long pensions introduce longevity risk, and this is the element that poses the greatest problem for traditional DC members, who face applying drawdown strategies and annuity purchase at retirement. It is simple, requiring no explicit action, and has been the backbone of the life insurance industry for centuries. If there were an easier path it would have been discovered long ago.

The presentation posed a number of questions; all of which have been answered many times before. But for completeness, they are answered again here:

“How are investment risks shared between different generations?” There is no sharing between generations, all current members face the common risk, and experience the common return of the collective asset pool, the pension fund.

“Who decides when target pensions are adjusted up or down?” Scheme rules will determine when pensions and the interests of members are adjusted. There should not be any discretionary element to this. In the absence of risk-sharing, the current pension payments would be cut when a deficit arises.

“How is asset allocation decided?” Asset allocation of the communal fund is determined by the trustees in the light of market prospects and the scheme’s specific situation.

“Who appoints Trustees? How are they paid?” Trustees are elected by vote of the membership. Whether they are paid or not is scheme specific, and subject to the approval of the membership.

Who regulates CDC?” This is an open question, to be answered shortly by the Department of Work and Pensions. However, it seems most likely that this will be the Pensions Regulator, rather than the FCA or some new body.

“What happens if people stop joining?” This takes us full circle back to scaremongering. CDC is not dependent upon the arrival of new members. It could run off over time, or it could be wound up immediately. This involves no loss of capital to any member. It could merge with another scheme. Members may anyway transfer the net asset value of their interest to some other qualifying pension arrangement at any time. In wind-up, CDC may revert to its traditional DC roots.

The design of a CDC scheme and the rules by which it operates are important. The start point is the award of some chosen benefit target and setting of its associated contribution. This is a matter of discretionary judgement for the scheme trustees. It should reflect their best estimate of returns achievable; it should not attempt to recover past shortfalls, nor to distribute any surplus.

The contribution made and the target benefits projected define a rate of accrual for the pensions, individually and collectively. This determines both the individual’s (equitable) interest in the scheme and fund, and the target liabilities of the scheme at all points in time. It would be totally inappropriate to value the target liabilities using gilts, the expected return on assets or any of the so-called fair value methods. This rate (with loading for administrative expense) also constitutes an explicit target rate of return for the asset portfolio.

If the trustees have been over generous in their awards, this will show rapidly as a scheme deficit which is persistent and growing; scheme rules would then intervene and cut the interests of all members. By similar token, pensions could be increased if the scheme is in surplus.

The concerns over intergenerational inequity are eliminated by the risk-sharing rules. There are many feasible designs and operations of these rules. We offer here one of the most elementary. The operation of these rules is simple. If the scheme is in deficit then, in the absence of the operation of the risk-sharing rules, the currently due pension payments will be cut by the proportion of the deficit. Simultaneously, the interests of all non-pensioner members will be cut in similar proportion. This will maintain equity among all members.

The risk sharing rules cover both the amount of total support available for pension top-up and the duration of rule operation. To avoid cuts, the most basic time limitation would be that deficits must be cured within a period which is inverse to its magnitude – a ten percent deficit within ten years, a twenty percent deficit within 5 years, and fifty prevent within two years – provided that the overall total support limit has not been reached. An overall limit to support is necessary to avoid downward asset spirals which would create inequities. The amount is scheme specific, but for a scheme with membership split 60 – 40 non-pensioner – pensioner, ten percent of the total assets is sufficient cover for all but the most extreme and unusual of market circumstances. The key to maintaining fairness among members is that along with the payment of the top-up to pensioners, the interests of all non-pensioner members are increased in similar proportion.

This alters the relative claims of non-pensioner members to pensioners. It also increases the required rate of return on the asset portfolio. The magnitude is though modest; if all ten percent were utilised the required rate of return would increase by approximately ten percent.

One positive effect of these rules is that they provide an incentive for new members to join when the scheme is in deficit. They will receive the best estimate award from the trustees and an immediate further increase from the operation of the risk-sharing support.

The asset portfolio has an investment horizon which is far longer than traditional DC, as it covers also the decumulation phase. While the traditional DC fund objective is to maximise asset values at all times (within a particular mandate limit) there is an explicit target return for the CDC portfolio. The presence of the risk-sharing rules further modifies this mandate. They lower the requirement to achieve the target return from an annual objective to achieving the target return on average over the period during which risk-sharing rules may be expected to operate. This permits truly long-term investment strategies, including those which are indirect in operation. As the fund is all there is to pay pensions, the performance of the asset portfolio is a central concern.

The degree of utilisation of the risk-sharing limit, and its related expected time to exhaustion constitute an important new risk metric for CDC schemes. It is the period within which pensions are effectively assured.

The question of communication with members was raised: would they understand that the pensions were targets, which might not be achieved? This feature can be explained in all introductory literature, and of course, it will be reinforced by the availability in near-real time of the asset value of the member’s interest together with the pension income equivalent of that, together with the original target.

Returning to the original debate, it is far from clear why these objections should be raised, beyond the venality of the fee bonanza around DC pots at retirement. The question which these objectors need to ask themselves is: what if I am wrong? If they are, and are successful in their efforts, then many pensioners will have been deprived of a good and dignified retirement. This is more than the best being the enemy of the good, it is a question of morality.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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4 Responses to Keating on Ralfe, CDC and morality

  1. As I have commented before on Con’s articles, I see little to fault in the theoretical logic here except that, when actually modelled in the context of the very high standard deviation of medium and even long-term real returns judgement about expected returns, it becomes clear that estimation errors will require much larger cuts in pensions (when there are based on mean expectations) than members will generally tolerate. This modelling, incidentally, is not fundamentally different to that required to optimise (subject to constraints) draw rates from an individual DC arrangement, which is something we have done a lot of.
    This variability issue is usually addressed by moderating the short-term portfolio variance by suppressing equity exposure – consider for example Dutch schemes, ‘third-way’ pension products (mostly now withdrawn) and modern with-profits variations such as Prufunds. The problem with this is that it negates the exposure to long-term risk-premium trends that Con suggests validate CDC.
    This then its not a problem of theory so much as practice. That’s why experience of parallel attempts at smoothing return variance is so important to reaching a policy consensus in the merits of CDC.

  2. Con Keating says:

    You are correct that the volatility of the asset portfolio is the prime determinant of the need to cut pensions in CDC. The fund is long-term in nature, but the determinant of the any to cut is the current volatility not the long-term. In the absence of risk sharing, a current deficit (with liabilities valued under the terms of award) should imply a cut in the current pension (and only the current pension payment) of the proportion of the deficit. It would also require a cut of similar proportion in the interests (pots, if you will) of non-pensioner members.
    The key to understanding long-term investment is to recognise that it is about the proportion of cash flow generated from the security itself, not the proportion arising from realisation in markets. In addition long-term investment does not bear the liquidity costs of traded, listed instruments. For many, perhaps most, instruments the volatility of cash-flow generation is a small fraction of that of market prices.
    Volatility of asset prices and their consequences are dealt with by risk-sharing among members. This is where CDC differs markedly from individual drawdown and the discretionary subsidy of with profits. There are some complex and non-linear trade-offs between the volatility of the asset portfolio, the amount of risk-sharing among members, its cost, and the specific demographics of the fund. However, modest levels of mutual support (say 10% of assets) are, in simulation, adequate to eliminate, for most schemes, the overwhelming majority of potential cuts even with all equity portfolios.
    One thing is completely clear: it is a mistake to derisk any open scheme. Its use in other locationsis a result of deficient scheme design and management practices. If you want to think of this as smoothing of return variance, then you really have to examine the cost of each smoothing intervention, together with the adjustments made to maintain equity, in the sense of fairness, among members.
    Much of this debate is presentational – do you prefer a 7% return with a fifty percent chance of 9%, or a 9% return with a fifty percent chance of 7%?

  3. Bob Compton says:

    Con, probably your best attempt at dealing with the CDC concerns raised by those that do not want CDC to become a reality. On the question of volatility, any CDC scheme that operates will need to invest in income generating assets, and as investing for the long term would want to ensure that the investments chosen generate income (along with new contributions) that matches or exceeds the pensions that are being paid out monthly to minimise the need for selling of assets for cash flow. I would remind everyone HMRC approval was given for pension fund investment (Long term) “short term trading” was deemed a business and taxable.

  4. Thank you for the response Con. I will share this with my quant colleagues.
    There are a number of points begging further explanation and these are perhaps what other readers might seize on. But in terms of my own key observation above, about stability of real income, the one most relevant is your reference to modest levels of mutual support being sufficient ‘in simulation’. This is not our own (Fowler Drew) simulation experience, albeit within the context of IDC. I don’t believe – but need to consider nonetheless – that there are fundamental contextual differences between CDC, with-profits and drawdown that invalidate the common implications of high variance in real equity returns at both short and very long horizons (even with the addition of geographical diversification and hence currency model effects). Less likely, the difference in conclusions is simply a function of different assumptions about the model parameter values.
    Anything you care to share with us about the simulations you have done would be gratefully received and we are happy to reciprocate.

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