The paper below is one of two that models what happens when CDC hits bad markets. I guess this one could be likened to launching a lifeboat into a stormy sea. CDC makes headway – but it’s tough. Imagine you’d put to DC in a less robust craft….
The modelling reinforces work produced by Aon illustrated in this chart (thanks to Kevin Wesbroom)
CDC – Early Days
This note considers the early days of a CDC scheme, the first ten years. It commences with just ten active members, but rises to a total membership of 13 by year 10. Contributions of 15% of pensionable salary are paid by each member and the award is 1/60th of final salary from age 65.
In particular we are interested in the effects of poor returns arising in these early years.
The contributions made, and the value of the total members’ equitable interest based on these awards are shown in table 1.
The rate of return on these targeted pensions is 5.57%. This is the objective rate to be achieved or surpassed by the investment portfolio. Next, we choose a set of random returns for the portfolio as we are most interested in the effects of poor returns, we choose the sequence shown below in table 2:
This sequence has an arithmetic average return of 4.58% and volatility of 17.7%. This sequence would not usually be considered adequate to achieve the required 5.57% of the target promises. The unpromising nature of this return sequence may be further illustrated by inspection of the evolution of both the arithmetic and geometric returns over the period – table 3.
Certainly, there are grounds here for considering replacing the fund manager as throughout this period trustees were consistently making new awards at rates of return in excess of 5%.
The extent of this mismatch between award rates and investment returns may be illustrated by comparing cumulative value generated by the rate of growth required (5.57%) with that achieved by the portfolio. Table 4
However, the scheme benefits from pound cost averaging, as contributions are made in each year. Table 5 illustrates these effects. This shows the actual deficits experienced together with the internal rate of return to that point in time. The averaging effect drives the experienced rate of return up to 7.25% in year ten. The table also shows the cure period associated with a deficit value
The simple rule for cutting is that the benefits must be cut if a deficit has not been cured within a period calculated as 1/deficit, expressed in years. In this case the deficit arising in year 3, 30.6% has not been cured after three years have elapsed. This triggers a cut in the interests of all members in year six equal to the deficit at that time (19.8%). This brings the fund and portfolio back into equilibrium. This is shown as table 6.
It is clear that the cut could be fully reinstated after year 10, and still leave the scheme in surplus. However, if this reinstatement is effected, pensioners in payment would have lost out in terms of the pensions they had received during the period when the cut was in effect.
Implementation of risk-sharing is discussed in a separate blog.