It seems natural for DC schemes to offer both drawdown and lifelong retirement income solutions. With inspiration from the design objectives behind Collective DC, it must possible to design something fit for the 21st century. Here are some thoughts on how to combine the building blocks.
Learning from past mistakes
Forced by the IT bubble bursting, the Dutch begun to transform their DB contracts into a form of variable annuities known as Collective DC. According to modelling done back then, CDC seemed to deliver outcomes similar to DB so it was ‘sold’ to members as an alternative ‘as good as DB’. This was an attractive narrative which avoided the closure of DB, as in most other countries.
An admirable ambition, but the devil in the detail was in the pension administration. In CDC, members were issued ‘pension rights’ in the same way as in DB – but with the difference that CDC rights were soft. This made the system inflexible, and problems arose when CDC schemes became underfunded. It was not clear how the pain should be distributed across different age cohorts in the collective.
Recently, the Dutch decided to reform their pension system. One of the main improvements in the new pension contract was to replace the old ‘pension rights’ with a ‘unit-based’ DC accounting framework.
Inspired by the ambition
How can we deliver the ambition of a lifelong retirement income, that strikes a balance between investment growth and income stability?
Let’s start by picking apart the old school CDC solution. The ambition had three key design objectives; First, the retirement income needed to be affordable – which requires taking financial risks. Second, to prevent a member outliving their savings, the individual longevity risk needed to be pooled. Finally, smoothing investment returns reduced short-term variation in payments.
Since biometric risks are not correlated with financial market risks, it is possible to separate management of investment strategies from longevity risk pooling. It is even possible to allow different investment strategies for the same longevity pool. Introducing individual smoothing mechanisms eliminates opaque transfers between different members in the scheme. Based on these insights, we can combine the building blocks using a modern unit-based DC administration.
A way forward
Old school CDC is not fit for the 21st century. To have a reliable stream of new members entering the CDC scheme, it requires some sort of (quasi-) mandatory participation. It also requires a dedicated organisation, so scale is crucial for success. In addition, each member in the scheme needs to hold the same investment portfolio and there is little flexibility for members.
The main challenge of implementing a new pension solution is operational challenges and costs, not the technical aspects. Today, most people save for their retirement in a DC scheme. In the UK, master trusts have emerged as the preferred multi-employer DC schemes and that is the natural vehicle for delivering a lifelong income to those members who are interested. To do that, it is important that all other members of a master trust are not affected (positively or negatively) by those who chose a lifelong income solution.
Value For Members
The fixed costs of operating the pension scheme have the largest drag on value for members. This is why regulators are so keen on driving consolidating in the DC pension market. A master trust in the UK, of sufficient scale, could offer a lifelong income solution as a complement to their drawdown solution. The marginal cost of adding a lifelong income solution is low.
Pooling longevity risk
Pooling of longevity risk can be implemented as a separate overlay, since it requires no upfront investment. Longevity pooling is like an insurance, where the savings accounts of those who died within the period are redistributed among those who are alive. The redistribution of mortality gains is based on proven technology, based on actuarial formulas and tables. In a conversation with Richard Fullmer
he hinted it is sufficient to have 500 individuals in a risk pool to reduce variability in micro longevity.
Formula for payments
It is straightforward to calculate the size of the pension payment for each period. It is a formula based on the value of the individual’s account, expected future investment returns, and forecast mortality gains. At the end of each period, realised mortality gains are added to the individual account and income for the next period is calculated. This takes care of short-term volatility, since each member is effectively smoothing with him/herself.
Manage investment risk
The diversified investment portfolio should have a robust trade-off between expected return and risk, since risk in the investment portfolio ultimately determines the magnitude of swings in the pension payments. As longevity risk is pooled separately, it is possible to offer a small range of investment strategies with different risks. The investment strategies could be built using funds already used for the savings phase. This means economies of scale will benefit all scheme members.
Delivering the CDC design objectives for the 21st century
This would be a cost-efficient way of delivering the design objectives of CDC, but in a modern and transparent way. Systemic risks are borne by the individual and the scheme is generationally neutral by design. Most importantly, it can be explained how it works in a non-technical way. In other words, it is the design objectives for CDC adapted for the 21st century.
We know that a lifelong income is not for everyone, but would be a welcome, cost-efficient substitute for traditional annuities. This has already been implemented in other parts of the world. QSuper in Australia created a lifetime retirement income product within their superannuation scheme. Purpose in Canada has a similar design, but delivered as a mutual fund. It is time to think about what could be done in the UK.