This is a blog by three bright consultants from Willis Towers Watson. I’ve been rude about WTW over the years but (as the picture shows) , there’s some sunshine after the rain. Thanks to my old buddy Anne “Freemers” Swift and to Simon and Henry for this affirmative statement of CDC’s worth in times of trouble.
How would recent market falls have affected members approaching retirement in a CDC scheme?
Collective Defined Contribution (CDC) is expected to be a new way to provide pensions in the UK from 2021, once the Pension Schemes Bill 2019/20 has achieved Royal Assent and the associated legislation is in place.
One of the aims of CDC is to smooth out the volatility in at-retirement pension levels seen in individual DC. This is done by sharing risk collectively between members and gradually varying benefit levels in reaction to market movements.
This way, benefits can be paid as relatively stable pensions, giving members greater certainty with which to plan for retirement relative to individual DC particularly during times of market volatility, but still be funded by contribution levels which are fixed in advance.
The first quarter of 2020, which saw the global equity market suffer a severe fall of around 20% in reaction to the Coronavirus pandemic, demonstrates this attractive feature of CDC as we explore in this blog post.
How would a CDC scheme have coped with the market falls?
As an example we’ve looked at the effect on CDC pensions under the design published by Royal Mail. We’ve looked at someone close to retirement who, in this scenario, would be able to retire as planned with no reduction to their retirement income.
Why is this case? Well, the Royal Mail CDC scheme design determines benefits as annual pension amounts based on career average pay, where the pension increase levels – both before and after retirement – vary each year in reaction to changes in the funding health of the scheme. Contribution rates are fixed in advance.
When the scheme is opened, there is a certain amount of ‘headroom’ in the contributions, designed to fund for future pension increases; it is only if the funding health suffers very materially that the headroom could run out and pensions would be reduced.
Based on Royal Mail’s scheme design, the initial headroom is over half of the contributions and is expected to provide for average long-term increases of 1% pa above CPI. It would therefore take a far more significant fall in markets for a member’s pension to fall; in the vast majority of scenarios, it would only be the level of future pension increases that would be at risk.
Under this design the Q1 market shock therefore has no effect on current pension levels for the CDC members – whether this is a current pensioner, or someone due to retire in the next few years. Instead it affects the next pension increase, and future pension increase expectations.
Based on the Royal Mail’s intended diversified return-seeking asset portfolio, we estimate that the collective assets would have fallen by around 7%. This reduces the ‘headroom’ funding for future increases but is nowhere near severe enough to remove it. In isolation this asset fall would have reduced future CDC pension increase levels by around 0.25% a year.
So, for a CDC member about to retire, there would have been little effect on their initial retirement income, but potentially a modest reduction in long-term future pension increases depending on how markets develop. As intended, Q1 market falls would have been smoothed out and the member could retire as planned without the need to face a difficult retirement decision.
How does this compare to individuals in DC plans?
The effect on each individual DC member depends on the timing of their retirement, their investment strategy, and how they plan to take their retirement savings.
For members many years from retirement, while the market movements might be disconcerting and had a significant impact on their pension pot, we expect the majority to make no changes to their retirement arrangements and wait and see how things develop until they are closer to retirement.
For a member due to retire in the near future with a typical drawdown investment strategy, we expect their pension pot to have fallen by c. 10% over the quarter. While this member could still choose to retire as planned without locking in this loss, as their pension pot will largely remain invested, the market falls will have introduced significant uncertainty for the member. This may require a rethink of retirement plans, for example changing their planned pace of drawdown or deferring retirement.
A member looking to buy an annuity will however typically invest in assets with less exposure to equity markets and have some bond holdings once they are close to retirement, so overall their pot will typically have remained broadly flat. However, prices for level annuities have become around 8% more expensive over the quarter due to falling bond yields.
This member is therefore left with a conundrum – go ahead and retire now on a pension which is around 8% less due to unlucky timing or, if he or she has the option through alternative income, defer retirement in the hope that markets and annuity prices eventually combine to provide a higher income.
In both cases, the market fall has therefore led to uncertainty and difficult judgements for the individual DC member near retirement. The CDC member on the other hand has been able retire on the income they expected, with a modest potential reduction in future pension increases.
1. DC analysis
We have assumed the drawdown member held 80% of assets in a diversified growth fund, which returned -12% over the quarter. For the annuity member, diversified growth fund holdings would typically be much lower, and government bond holdings would have typically achieved 6% returns over the quarter which would counteract the growth falls.We have based the 8% movement in assumed annuity conversion rates on market pricing for a single life level annuity for a member aged 65.
2. CDC analysis
CDC schemes would usually be relatively large, and would typically have the scale to invest in a well-diversified return-seeking portfolio which could include private markets, credit and infrastructure. CDC schemes will be subject to the charge cap and, based on our modelling, asset splits and expense approaches are available which allow such diversification at costs within the charge cap. Based on the intended asset strategy we estimate falls in return-seeking asset values over the quarter of around 7% – this is less than half of the global equity market falls due to this diversification.Under the Royal Mail CDC design, pension increases are determined as follows:
- Each year there is an actuarial valuation on a best estimate basis.
- The purpose of the valuation is to determine the long-term pension increase rate which results in a 100% funding level, ie the pension increase rate which the assets are assessed as being able to fund over the long term.
- That long-term pension increase rate is then applied in the current year.
- This increase will be applied both to pensions in payment and to the accumulated pensions of active and deferred members.
As set out in the blog, we have determined that the asset fall over the quarter would have in isolation reduced future CDC pension increase levels by around 0.25% a year. The total change in this year’s CDC pension increase would also depend on any changes in future asset return expectations or demographics.The 0.25% pa reduction in pension increase levels would be a planned long-term reduction to increases, subject to revision each year. For example, the following pension increase would then take account of any market recovery or further falls over the next year. Over the long term, pension levels will be higher or lower than expected depending on how markets develop and valuation assumptions change.
3. How does DB compare?
Defined Benefit schemes are another matter entirely. A member enjoys the security provided by the employer and the PPF, but the employer faces the ‘double effect’ of the crisis on both its business and its pension scheme (unless the scheme is both fully funded and fully hedged). Trustees must grapple with whether a weakened employer covenant can cope with an increased deficit, and contribution level negotiations can be difficult to conclude. Funding rules mean that, over the long term, calls on the business for pension funding are ‘lumpy’, and often come at a bad time. That all comes as a consequence of the employer providing a long-term guarantee of pension levels.