This blog from Con Keating is technical and designed to help the DWP ,tPR and others , when thinking about how to encourage inflation protection in the pathways on offer to savers in retirement.
Member options for retirement income
In this note we consider a range of possible retirement income choices available to a CDC scheme member at the time of normal retirement age assumed to be age 65.
In these simulations, we consider the investment return to be 5% pa (for income drawdown and CDC pension), and inflation, 3% pa. If the achieved investment returns are higher than this, then the pensions paid will be higher, and if investment returns are lower, then the pensions paid will be lower.
The assumed investment return for the insurance company written annuity is 2% pa. This pension is assured.
All pension payments are annual in arrears.
We assume an initial endowment (or capital amount) in each case of £100,000. We use a current gender-neutral mortality table, which is shown in Figure 1.
Expected life span at age 65 is 88.5 years.
We start with income drawdown. This product is not guaranteed in any way and so the member bears all investment and longevity risk and return. The pension drawn is that which will completely exhaust the fund by the age of 105.
In figure 2 we show the annual pension income and the residual value of the ‘pot’ which is available to the member’s estate and heirs. The level pension is £5,782.23 pa while the indexed pension starts at £3,666.58 and rises to £11,960.52 at age 105.The indexed pension is larger than the level pension for the first time at age 81.
For the level pension, the residual value of the pension ‘pot’ commences at £99,218 and declines monotonically thereafter. By contrast, the indexed pot commences at £101,333.42 and rises until age 79 where it reaches a maximum of £112,385.60 before declining as it is depleted by pension payments. The indexed ‘pot’ does not fall below the initial £100,000 until the member’s 90th year.
It is worth noting that the differences in cash flows between level and indexed drawdowns mean that the indexed portfolio earns more investment income and offers higher total pension payments than the level – the difference can be substantial, with total income for indexed being £288,425.27 and for level at £237,071.43, a difference of 21.7%.
Next, we consider CDC pensions in level and indexed formats. Firstly, in the case where all longevity risk is collectively shared resulting in the loss of any ‘pot’ value on death. Secondly, in the case where there is a 20-year guarantee of minimum duration of payments; in other words, there is a bequest value during the first twenty years of pension payments.
The base case can be seen to increase the pension value from £5,782.23 pa of individual drawdown (with no investment penalisation) to £7,831.15 ( 35%) and for the indexed form, from £3,666.68 to £5757.20 (57%). Longevity pooling is very powerful indeed.
Figure 3 also shows the pension value when the scheme offers a guarantee of the first twenty years of pensions (Strictly speaking this guarantee does not encompass investment performance which may lead to variation of the pension). The cost of the guarantee results in the scheme offering level pensions of £7,121.37 (90.9% of the non-guaranteed) and indexed commencing at £5,195.03 (89.8% of the non-guaranteed). Of course, should a member die within this twenty-year period, they will receive a refund of the unspent guaranteed sum which has starting values commencing at £86,064.04 for the level and £81,889.38 for the indexed. Note that these refund amounts are lower than in the individual drawdown residual values. (It is the present value of just the remaining payments out to twenty years, rather than all remaining payments which is the drawdown case.)
As it is often overlooked in discussions of pensions, we may examine the significance of post-retirement investment income on the pension received. With no investment income, the £100,000 endowment will deliver a level pension of just £2,439.02 in drawdown – just 42% of the earlier £5,782.23. The indexed pension would in this case be £1,129.83, down from the earlier £3,666.58 (31%).
In the case of CDC, with no investment income, the level annuity would be £4,342.19 and the indexed £2,836.64, down from £7,831.15 ( 55%) and £5757.20 ( 50% ) respectively. The lack of emphasis on post-retirement investment income in the retirement literature is, given its importance, surprising. The ability to maintain high growth (and expected return) allocations in open CDC schemes is a source of much of its comparative advantage.
The final comparator is the use of an insurance company issued annuity. We show again the level and indexed forms, with and without a twenty-year guarantee, but here the investment rate assumed is 2%, reflecting the constrained opportunities available to regulated insurers.
The level annuity rate in this case would be £5,629.23 with no guarantees and £5,080.14 with a twenty-year guarantee. The indexed variants would be £3,891.56 and £3,498.89 respectively. The refunds on early death, within the 20-year guarantee period commence at £79,648.78 for the level pension and £73,396.32 for the indexed form.
The table below shows the choices for the member to make in terms of risk/return trade off for income levels while alive and the cost of providing a survivor benefit/bequest on death:
|Income drawdown payable until fund exhausted (or earlier death-balance to survivor on death before fund exhausted) – amounts not guaranteed||CDC pension payable for life (amounts not guaranteed)
|Annuity payable for life (assumes standard health and no individual underwriting which could increase (impaired life) or decrease (greater than average longevity identified)
|1.Level: Starting amount £pa||£5,782.23||£7,831.15|| £5,629.23 guaranteed
|2.Indexed:Starting amount £pa||£3,666.58||£5,757.20|| £3,891.56 guaranteed
|3.20 year guarantee period:
3.1 Starting amount pa: level
3.3 Starting amount indexed
3.1 £5,080.14 guaranteed
3.2 £3,498.89 guaranteed
Some points to draw out from the figures
Deterministic not stochastic: In these illustrations, the investment returns have been deterministic and fixed. This masks the fact that with CDC or indeed individual drawdown the pensions paid may vary with investment performance, while the embedded return in the insurance company annuity is fixed.
Risk: The values quoted have also given no weighting to the relative riskiness of these strategies. We have shown the pension arising from individual drawdown achieving the same 5% investment return as the collective pooled risk of CDC. In reality, the risk-aversion of the individual is likely to constrain their investment to something close to the 2% of the insured annuity. In that case, individual drawdown would look very unattractive indeed offering just £3,597.19 as a level pension or £2,033.20 as an indexed pension. There is of course the possibility that individuals would adopt a different approach, one which is risk-taking, However, this would be suitable really only for pensioners with other meaningful financial resources.
Duration: The indexed form is longer in effective term, or duration than the level annuity. This is colloquially known as the ‘time to get your money back’. The level pension has a duration of around 11 years and the indexed around 13 years
Sensitivity to changes in longevity assumptions: The sensitivity difference to longevity assumption changes is pronounced . A one-year increase in life-span increases the level pension cost by 4.4% while the indexed would increase by over 13%.
Sensitivity to investment return changes : The sensitivity of the CDC pension to a 0.5% lower investment return is greater for the indexed but only marginally: the level falls to £7,444.55 from £7,831.15 (5.0%) while the indexed falls from £5,757.20 to £5,421.47 (5.8%).
Figure 5 shows the CDC scheme’s pension payments under both 3% and 3.5% inflation
The scheme’s income is fixed at 5% which carries the consequence that additional income can only be generated by variation of the rate of pension payment. The pension payment commences at £5,116.82 down from the earlier 3% base case of £5,421.47 ( -5.6% ). The total paid in pensions increases from £189,321,10 to £192,656.20
Given the complications introduced by indexation, it is difficult to understand why the DWP introduced a performance test for member contributions to a CDC scheme linked to inflation, when this could have been achieved much more simply by specifying a minimum investment return.