We aren’t all Thatcher’s children
Ros Altmann has put a resolute defense of the status quo as a comment to my recent blog “barriers to CDC”.
Nobody would accuse Ros of lobbying for the vested interests of the pension industry, nor of a lack of emotional intelligence into the way people think, I simply think that on collective DC pensions she has a blind spot.
Here is her comment, which I thank her for.
Could I suggest there are at least three other very big barriers to the sustainability of collective pensions, which mean they may be more like DC with added risks, rather than akin to DB.
In particular:
1. Pension Freedoms (which allow people to transfer out and potentially select against the remaining scheme members by taking a value that could be inflated in the short-term – either because markets have done very well, or because they know they are in poor health, or they are just fortunate in their timing and prefer to pass on an individual fund to next generation without needing much pension income
2. Inter-generational risks, where the young may find the fund does not look after them in the distant future – this extrapolates from the problems of DB sustainability, with schemes looking well-funded in the early years, as few pensions are being paid out, while plenty of contributions are coming in, however over a series of market cycles those who have already taken money out or received early pensions may have received more than was sustainable in the long-run
3. Lack of inflation protection – DB became so expensive and ultimately unsustainable partly due to the requirement to add inflation protection. Especially after QE and the ultra low negative yields on inflation-linked gilts, there are concerns that this could result in large problems for those who lock into fixed incomes for 20, 30 or more years. That was part of a problem with the old mandatory annuity rules, where people looked for ‘best rate’ without realising the product itself might not be suitable for their long-term future
I do worry about the long run here, even if there are short term attractions to pooling. It seems to me that much of the benefit of CDC, relative to DC, is more about economies of scale which can lower costs and improve investment performance in theory, rather than hugely improved pensions being sustainable for many decades.
The individual flexibility and adaptation to individual health circumstances is important as people get older, but are not yet factored into CDC as proposed. There are not even any risk margins foreseen which could avoid some of the selection bias for those transferring out.
Of course, others will disagree, but just thought it might be helpful to air some concerns at this stage
All best wishes
Ros
Why I disagree
- Freedom for those who want it. In a further comment, Bob Compton makes an interesting suggestion ““as I understand CDC as promoted by Con and others a truly effective CDC scheme would only ever an individual member pensions or transfers out based on their individual share at any given point. I appreciate however CDC schemes would be available with different structures, where Ros’s concerns would be real.
The future for CDC has to be Master trust based with the creation of CDC sections in those Master Trusts that will dominate the DC AE world over the next 10 years as the AE market evolves and matures. Stephen Timms committee I hope will see this is the way forward for all AE members to have a new choice to be able to have at least a part of the later years income to be as dependable as their state pension, with drawdown for any balance being the raining days pot”.
- Intergenerational issues; I remember going to a lecture given by Bryn Davies, who also comments on this blog. Bryn talked about intergenerational solidarity and of how pensions could be supported on an unfunded basis by a covenant to pay tax and see taxes paying pensions. CDC is not unfunded (though you could say that Serps and S2P were unfunded CDC schemes to an extent). Younger people have , since the war, had an expectation of having more than their parents and for the first generation in a while, the millenials don’t feel that way. Whether it be the climate or the economy, job or pension prospects, there is a lot of fear among the young that they are being shafted by the boomers. I get there frustration, but I don’t think it does society or pensions any good to pander to it. The alternative to CDC looks a whole lot worse than the intergenerational solidarity that CDC plays to. While there is a risk of one generation taking the money and leaving the next to pay for nothing, this risk is inherent in any long-term plan and can only be mitigated by dumbing down – which is what the current mania for de-risking does.
3. Lack of inflation protection Few but actuaries understand the value and the cost of inflation protection within DB pensions. I can be as much as one third of the total funding cost for a DB scheme. So when CDC actuaries like Kevin Wesbroom explain that CDC can manage all but the most severed market downturns through fiddling with the rate of indexation, they’re playing with a pretty big dial. The difference between getting the indexation and not isn’t felt in the early years of payment but towards the end when the compounding effect of increases is most obvious.
Critics of CDC for paying too little up front and too much pension when people are too infirm to spend it, may argue that indexation is a bad thing. What is clear to me is that indexation acts like a weir on a river, regulating the flow of returns through sluices turned on and off by people who do the maths. Defined Benefits lost the ability to control the flows when indexation became mandatory, annuities have generally been bought without indexation.
If CDC schemes wanted to offer optionality, they could offer differing levels of indexation to members as a choice at outset. But are people wanting to make such choices? Ros is right to say that CDC is not the “gold plated” benefit of a fully inflation protected DB scheme but that is very much the point, if CDC offered this guarantee, no one could afford it.
Final thought- CDC is not one of Thatcher’s children
The opt-out of CDC is vital. No-one should be required to stay in a CDC and I do believe that CDCs in payment should have a transfer value. Ros is worried that CETVs in payment would risk those with reduced life expectancy diminishing the pool’s longevity pooling and I’m sure that some people would transfer out on medical reasons with a hope of boosting their income or leaving more for the kids. But this is assuming a pension savviness of which I see little evidence today. All the evidence is that those who would most benefit from pooling of longevity risk, shun the pool. Rich healthy people prefer drawdown increasing the pension prospects for those with smaller entitlements (who statistically live shorter). The assumption that people behave rationally is not born out by people’s behaviour.
Actually the unions , as Bryn points out, have much to say about CDC because it is a unionized product. Here is Bryn commenting on the blog
You miss the biggest barrier, which is convincing employers that there’s something in it for them in the absence of effective trade union pressure.
But Bryn misses Bob’s point. it is not the employer who needs convincing, it’s the funder of the commercial master trust. Unions can and should be turning their attention to lobbying the schemes that are increasingly the guardians of our pension benefits and many of them are mutuals (Evolve, Nest and People’s Pension). The principles of mutuality on which both unions and collective pensions were founded, have never been so important.
Ros’ blind spot is that she doesn’t get mutuality, she is Thatcher’s child and that is her great strength but also (when it comes to this issue) her weakness.
Margaret Thatcher and her children
Ros makes much of members transferring out of CDC schemes. So, I will make the most important point of scheme design in this regard. Provided transfers are made at the net asset value of a member’s equitable there will be little or no material consequence – the scheme will be a little smaller.
Ros’s concerns with flexibility are misplaced. The concern “The individual flexibility and adaptation to individual health circumstances is important as people get older, but are not yet factored into CDC as proposed.” It is perfectly possible for a scheme to have lifetime income and drawdown arrangements, including term annuitisation, available to the pensioner member throughout their life. The key again is transfers at the net asset value of the member’s equitable interest. The option to commute part or all of a pension at any point in time for all pensioner members can certainly be a feature of a CDC scheme; drawdown need not be a cliff edge single decision.
It is interesting to investigate empirically the characteristics of scheme members taking transfers from DB schemes. Contrary to the concern with the short life member, the majority of those taking funds out are the highly educated, highly paid members with larger pots and typically longer life expectations than average. These members dominate over ill-health withdrawals; one of these transfers is typically around three times as significant as the ill health withdrawal. My attitude is that we should encourage the terminally ill to take their money and enjoy it in the little time that remains to them.
Within a risk-sharing collective CDC scheme, another of Ros’s concerns is misplaced: “ There are not even any risk margins foreseen which could avoid some of the selection bias for those transferring out.” It is the non-pensioner members who provide the risk-bearing capacity of the scheme for the benefit of pensioner members. This is unchanged in amount by the withdrawal of some pensioners, and that means that the margin of risk coverage of the remaining pensioners is increased by precisely the amount of the withdrawals.
Iain Clacher and I have been asked to write up fully our preferred design for CDC schemes for the Institute and Faculty of Actuaries, when done we will provide a synopsis here.
just noticed – in the first paragraph above equitable should read equitable interest – it may be convenient to think of that as the member ‘pot’- the nav of the equitable interest is indeed the ‘pot.’
My comment was cross-posted with Bob’s and he makes an important point that I missed. But we know that under auto-enrolment the decision about where the member’s money goes is effectively the employer’s – i.e. the default. So the employer would still have to be pursuaded to choose the commercial master trust’s CDC product as the default.
Dear Henry and Con
This is a really important debate and I respect your views, but still beg to differ and offer some further thoughts. I am not against CDC, but believe that, as currently proposed, there are serious risks that I fear members and employers will not necessarily understand. Those who do understand are likely to be in a position to benefit themselves at the expense of others, For example, given the risk of selection by older members at times of market strength, and lack of individual flexibility to adjust for severe health changes, the CDC pensions in the early years of scheme could turn out to be far more generous than will be affordable in future decades. Members would need to be led to believe that this CDC pension is going to stay roughly stable over time, or perhaps increase, with some downside risk that is expected to be only very short term. But we know that markets don’t work like that and, unlike DB, there is noone to pick up the slack in poor market periods. And how would the pension fund cope with a Japanese style market downturn, or an unwinding of QE, or rising interest rates due to higher inflation than markets previously anticipated? Or if some of the investments fail on a larger scale than expected?
I do believe that allowing people to transfer out at full market value is not prudent – if they choose to leave they should take a reduction as a risk margin or buffer against future market downturns. Either they will be transferring because of poor health, in which case a reduction would not be unfair (transferring at full value in such cases is also selecting against the mortality cross-subsidy), while wealthier people transferring out to have their own freedoms or IHT benefits should also be able to afford to pay a risk-premium for not relying on or remaining in the scheme along with all other members.
I did try to get such risk margins approved during the passing of the Pension Schemes Act, but sadly this was considered ‘unfair’, whereas I truly believe that not taking some reductions on current market value of members’ share is actually the unfairness to the scheme as a whole.
If CDC is to work, members need to know the honest truth- which is that they cannot really rely on a future pension of any particular magnitude from this scheme. The scheme and its actuarial or investment experts will do their best to provide what looks reasonable in today’s circumstances and with extrapolation of past performance to tomorrow’s markets, but this can only be an estimate, not any kind of guarantee, especially in real terms. Indeed, in extremis, younger members could theoretically receive very little, if there is a catastrophic failure of the investments or too many older members took money out or were paid out higher pensions than the forthcoming performance managed to justify. DB never had any buffers against bad markets when the MFR was set, indeed the Government penalised so-called ‘surpluses’ and thereby discouraged them from being retained, whereas they were sorely needed during the early noughties and non-pensioner members were seriously let down.
In summary, my view is that CDC can make sense because it provides the benefits of economies of scale, access to better ‘expected’ return assets, more professional management and possibly lower costs for members. However, CDC needs careful handling and is likely to work more fairly for the majority of members if proper risk warnings are given, if risk margins are taken from those wishing to transfer out, if there is clear explanation of how younger members’ funds will be used and if expectations of a particular pension are couched in cautious language.
Thanks for engaging with this. I look forward to further thoughts on this really interesting topic.
I count myself as a ‘Friend of CDC’ but not an outright supporter. In particular, I don’t see CDC as the only means of providing a stable pension outside of a DB scheme. However, for the moment, let’s consider a key element of CDC set out by Con as “the net asset value of the member’s equitable interest”. Con sees “equitable interest” as the market value of the securities backing the member’s pension liability. I note Ros believes it should be a lower figure. I would say that it could be lower. Why? Well, I come from a generation where your investments produced income, either dividends from shares or interest from bonds. The price of securities on a particular date was just that, the price that matched the marginal buyer and seller at a point in time. What matters to a long term fund is the fundamental value of its securities, driven by the income they produce. Sadly, ‘mark-to-market’ has become the bane of our pension lives!
I have two comments on the proposed design of the Royal Mail CDC Plan:
1. I don’t believe it is fair that an 80 year old pensioner bears the same ‘Pension Adjustment’ risk as
a 30 year old member. I fully respect Royal Mail’s right to adopt such an arrangement, if the
members are content with it, but I wouldn’t want it to become an ‘industry standard’. The key
issue is that the 80 year old has only a matter of years left for any annual pension reduction to be
recovered whilst the 30 year old’s accrual shortfall can be compensated for over decades.
2. The ‘Key Investment Principle’ is that members’ pensions are supported by 100% in ‘Return-
Seeking Assets’ up to age 67 (NRA) switching to 100% in ‘Low-Risk Assets’ from age 90
onwards. One might quibble about the switching being ‘uniform’ over that 23 year period, given
the pattern of mortality between those ages, but this principle should be strongly supported. It
highlights what a nonsense it is for DC schemes to continue to adopt a ‘lifestyle’ default strategy
that reduces ‘Return-Seeking Assets’ from 100% to 0% over a 10/15 year period prior to NRA!