This is the first of series of blogs which will consider the CDC consultation currently under way. The author is Con Keating who’s confidence in CDC succeeding appears to have diminished as a result of tPR’s consultation into its CDC Code.
You can hear Con in person on this subject at a Pension PlayPen coffee morning on Tuesday February 1st (tomorrow) at 10.30am. I will be in conversation with him
The link is here – or cut and paste this URL into your diary.
CDC Code – A Personal Perspective
My interest in CDC schemes stemmed from the difficulties experienced by, and near-total demise of private sector defined benefit pensions. The particular appealing property of DB schemes is that individuals who possess them live longer healthier lives in retirement than the population at large. This is a long recognised actuarial fact and the reason that separate life tables have been constructed for them. History will not judge the Pensions Regulator kindly in this regard; it has zealously presided over and accelerated the demise of DB. I would want to lay this just at the feet of the Pensions Regulator- Parliament has proved a willing and able accomplice. The pursuit of the votes of those who might lose out by adding guarantees, removing safety valves and approving completely disproportionate funding codes has proved irresistible.
The precise mechanism driving this gain in lifespan is unknown but the absence of stress and worry over financial security in older age are clearly part; the wealthy do live longer. It appears, though the evidence is anecdotal rather than academically rigorous, that DC pension holders do not benefit to a similar extent. Indeed, the problems of DC decumulation are a significant source of stress and worry for DC members.
In the hope of achieving gains comparable to DB, the objective of CDC was to alleviate this stress and worry to the greatest extent possible, though made more difficult by the need to ensure that members understood that the pensions were aspirations, which might fail to be achieved. This makes communications with members both crucial and nuanced. Disappointingly, the Code seems to regard this as an IT problem.
“The scheme must have adequate systems and processes to communicate with members so they understand the risks and benefits of the scheme in particular how target benefits may change.”
It has been suggested to me that my reading of the Code here was “too literal”, that
“What the employer, the government and the Regulator want to achieve is a scenario where there is a red hand dripping blood that you see every year to stop you claiming that ‘you were robbed/misled etc’. The systems and controls are there to try to stop the ‘emphasise the positive, do not tell them about the risks except in the legal boilerplate that they won’t read – the speciality of communication consultants and salesmen (the mis-sellers par excellence).”
The problem with that of course is that it is unlikely to build member confidence and create the stress-free conditions for a longer, healthier retirement.
The question here, as it was with DB, one of proportionality. The risks involved in CDC are small, but they occupy the overwhelming majority of the draft Code. It seems that the costs of compliance with the proposed Code are likely to exceed the risks faced by scheme members. Those costs alone would exceed the charge cap, if it is to apply.
Before addressing the Code proper, it is appropriate to consider why we might wish to seek authorisation. The answer to this lies in the relatively preferential tax treatment offered to authorised schemes, and of course historically, authorisation lay within the ambit of HMRC.
Prior to reading the consultation documents, my understanding was that from an annual allowance perspective, a CDC scheme is treated as DC and not DB, but for lifetime allowance purposes it is treated as DB, and that
- employer contributions are tax deductible
- member contributions are tax deductible
- no benefit in kind charge as long as member plus employer contributions do not exceed the Annual Allowance
- no NIC charge on employer[i] contributions
- investment income and investment gains are free of tax in the CDC scheme
- 25% of the commuted value of your CDC benefits is tax free up to your LTA
For LTA purposes, the annual starting amount of CDC pension (before commutation) when drawn is multiplied by 20 to test against the LTA (just like DB) and the allowance for future indexation is not priced.
However, as the consultation documents make clear, lump sum arrangements are non-qualifying. If this means that CDC schemes will not benefit from a lump sum concession, it is only the deferred tax aspect which will apply. For a standard-rate taxpayer, with plausible assumptions, these are relatively modest advantages when compared to other (taxable) savings arrangements – in investment return terms, of the order of 1% – 1.5%. If the costs of compliance exceed this, it makes no sense to seek or maintain authorisation in CDC format.
Obviously, these costs are institution and design specific, but for the three employer groups I have been working closely with, the costs of compliance under the proposed code would exceed both the risks and the benefits. For them, authorisation compliance costs would take 5 – 8 years to recoup and annual compliance costs and administration expenses would run between 2% and 3% annually. This raises questions: could schemes with this level of charges possibly be authorised and how would the charge cap be applied?
Unfortunately, I am left with the impression that the Pensions Regulator is uninterested in minimising the costs of providing CDC pensions under the legislation in force and is prepared to create additional costly obligations, regardless of their cost, for trustees to comply with. Indeed, they are already saying so – David Fairs
“The draft code focuses on requirements that employers and trustees considering establishing a CDC scheme need to plan for now. We will be revisiting the code to expand on our expectations for the closure or wind up of a scheme in due course.”
The CDC Code Consultation
Moving to the consultation itself, it creates the impression that it is a consultation in form only – to tick the box of having consulted, as is required by PSA 2021, ahead of laying the Code before parliament. It provides a specific and restrictive format for responses; charts and tables seem to be impossible to embed. All of the questions require a binary yes or no answer; there is no room here for nuance or qualification. There are twenty-seven questions, of which twelve are explicitly of the ‘what should we add’ type, and at no point does the consultation pose the question ‘what should we remove’.
This is extremely surprising as there are many elements which are inventions of the Regulator and unsupported by either the Act or Regulations. The Code requires the production of a governance map, which has no support in the legislation – it seems that cartographers will be in demand and judging from the two graphics produced by the Regulator are much needed there.
Prudence does not appear in PSA 2021 and in Regulations we only have:
“central estimate” means an estimate that is not deliberately either optimistic or pessimistic, does not include any margin for prudence and does not incorporate adjustment to reflect the desired outcome.
It appears four times on the Code. For example, “the CALP (Costs, Assets and Liquidity Plan) should
- Include an explanation of assumptions and levels of prudence adopted in various elements of the document.”
The CALP is another introduction of the Code where it appears twenty-four times – the closest I have been able to come in search of support for that concept in legislation is in PSA 2021 14 (4) (b) which covers the Financial sustainability requirement and states:
“(4) Regulations under subsection (3) may include provision – (b) specifying requirements to be met by the scheme relating to its financing, such as requirements relating to assets, capital or liquidity.”
However, subsection (3) limits the role of the Pension Regulator – “…, the Pensions Regulator must take into account any matters specified in regulations made by the Secretary of State.”
Notwithstanding this, the CALP has some onerous requirements:
“The CALP should:
- cover a period of three to five years from the point the trustees agree it
- include an estimate of the trustees’ risk appetite for their financial reserves
- contain a statement about the level of prudence in their estimates
- include an assessment of the different levels of liquidity needed throughout the period covered by the CALP and continuity strategy
- identify the reserves allocated to each section separately where there is more than one section
- include an explanation of assumptions and levels of prudence adopted in various elements of the document
- give a range for any variable items, explaining how it was reached
- explain why any element omitted from it cannot be provided
The information in the CALP is grouped into four sections:
- Costs in relation to benefits
- Income in relation to benefits
- Assets held to meet costs in relation to benefits
- Liquidity of those assets.”
And the list of prescriptions for these four sections is many pages long.
Note the prominence of “reserves” in this listing; the word appears forty-three times in the Code but is entirely absent from PSA 2021 and Regulations. The concept is economically and financially illiterate. It would appear that it has been borrowed unthinkingly from bank or insurance risk management practice. All of the assets of the scheme are, in principle, the property of members[ii]; there is no hierarchy of priority of claims on the assets. The wealth of a member is unaffected by the pocket in which he or she keeps it – the concept of any gain from the haircutting of some assets is simply laughable.
Before producing that CALP listing above the Code states:
“The trustees should produce the CALP with the co-operation of any sponsoring employers.”
Similarly, I have long been concerned that PSA 2021 specifies sponsor insolvency as a trigger event for a CDC scheme. Given the experience of DB costs ballooning, an absence of any obligations on or recourse to any sponsor is a sine qua non for their sponsorship.
To end on a lighter note: I was amused to read that in the topsy-turvy world of regulation “a continuity strategy is a document …”. But that does illustrate and support the idea that the Regulator’s concern is with the documentation of a scheme rather than its operational effectiveness and efficiency.
[i] Employee contributions are tax deductible by the employee subject to the AA point but are paid out of post NIC pay which is why salary sacrifice as a way of paying employee contributions is so popular.
[ii] Members of CDC schemes may have to provide for potential winding-up expenses during their membership of the scheme, but this provision should drop to zero as their pension obligations are discharged. Any other approach creates deadweight costs for the scheme and its members.