The global challenge in pensions is to solve the pay-out phase. A popular vision, among pension policy people, is to introduce a life-long income but without the drawbacks of annuities. In the UK, many advocate for Collective DC (CDC) as the solution.
The biggest advantage of current CDC over traditional DC is that longevity pooling allows for a longer investment horizon. So why don’t we lengthen the investment horizon for traditional DC through longevity pooling and avoid the complications of current CDC? In my view, here’s how we can do that.
From a product design perspective it is not that complicated to extend the investment horizon for traditional DC. In a Master Trust, this can be achieved by adding a separate section allowing pooling of longevity risk. In its simplest form, the longevity section would have one investment portfolio. From conversations with fellow pension experts, the main reservation of the traditional DC with longevity pooling concerns the investment side, so let’s investigate that.
Growth and liquidity
A strong argument for current CDC is the almost perpetual investment horizon which allows for holding both growth assets and illiquid assets. In theory; higher investment risk translates to higher pensions and illiquid assets are expected to deliver a higher return than corresponding liquid assets. The attractive outcomes that are attributed to current CDC assumes that the alternative is traditional DC where the member ends up taking a drawdown option and that the pension savings are invested in a less risky portfolio.
A DC Master Trust with a separate section where individual longevity risk is pooled, can hold the same investment portfolio as current CDC. The investment magic of pooling is that when someone dies, the assets are not sold on the market, instead the ownership is redistributed among the existing members. This has a couple of attractive consequences with respect to the investment horizon and liquidity.
The investment horizon, in run-off, is the capital weighted remaining life expectancy of the members in the dedicated section. As new members are expected to enter the longevity pooling section, the actual investment horizon is much longer than that. The annual liquidity planning for the investment portfolio, is determined by the net of pension payments and new members transferring-in their pension pot. The annual liquidity requirements are relatively small in relation to the overall section and until the longevity section matures, there is likely to be a net inflow so liquidity should not be a practical obstacle.
Investment risk and stable outcomes
The challenge for both current CDC and the proposed DC with longevity pooling is to combine a high allocation to growth assets with a reasonable stable annual pension payments. The simplest approach is to smooth the investment return over time. In current CDC, the idea is to do that over all members including future participants, resulting in intergenerational transfers. This requires that we put limits on how much investment risk we can transfer to other generations.
In traditional DC with longevity pooling each individual smooths their investment returns with themselves. This makes the assumptions on future investment returns less important. In other words; you may fool yourself but you don’t get fooled by other generations. This requires that the formula for paying out pensions from the individual savings pot is based on realistic assumptions about future longevity gains and expected investment returns and that an individual smoothening mechanism is applied.
A bit simplified, the proposed approach means that longevity risk is pooled, investment ownership is pooled (so assets not sold on death), but investment performance is not pooled. For a decumulation product, this makes the entry pricing more robust since it does not involve accrued deficits/surpluses or any assumptions about future investment returns.
The difference between theory and practice
In theory, both current CDC and DC with longevity pooling are expected to deliver similar outcomes. From experience, we know that there is a massive difference between practice and theory. In theory the financial markets are benign and well behaved and all investors are fully rational, in practice unfortunately that’s not really the case.
So, what should we prioritise when making a choice between two solutions with roughly similar estimated outcomes? In a perfect world, which matches our model, we should choose the solution that optimises the outcome based on our assumptions. In the real world though, we should pick the solution that is most robust in case our assumptions happen to wrong. This is known as satisficing and it is closely aligned with info-gap theory in engineering.
The key question, when evaluating a pension solution, is: what happens when our assumptions are proven to be wrong? In other words, how will the pain (or gain) be redistributed if things are not going as expected? How will a discontinuation of the scheme be managed? What if the past 40 years of market performance does not repeat itself? In most of these cases, the proposed DC solution with longevity pooling, implemented within a Master Trust, will be more robust and fair across all members compared with more complicated CDC solutions.
Making it happen
There are business reasons explaining why Master Trusts have not yet moved in this direction. The two main reasons are; legal barriers and limited demand from members. The first can be eliminated by establishing this solution as one of the CDC models in the new regulation and opening up for a light touch approach so that Master Trusts can offer a pay-out solution where longevity is pooled.
The second reason can partly be explained by the fact that most Master Trust members are far from retirement, but that is changing rapidly so demand from members is likely to increase. To make CDC successful, it needs to build on existing industry capabilities. A master trust offering traditional DC with longevity pooling for the decumulation would do so not simply to the funds it built up in the accumulation phase, but also to funds transferred-in from other pots the members have.
As part of the upcoming CDC legislation, it would be welcome if DWP would include a light touch CDC approach, for the decumulation phase, based on traditional DC with longevity pooling. This, combined with a clarification that Master Trusts could use a dedicated section for implementation, would open up a low cost solution for those members who want to have a lifelong retirement income without introducing the complexity of the current CDC solution.
Let us not forget: No pension plan ever survives contact with the Pension Regulator.