Michael Jones is a Pensions Partner at Sutherlands Eversheds. Yesterday he published on linked in an article first published in Professional Pensions: CDC in decumulation – five key strategic areas for focus (professionalpensions.com)
The importance of one of Britain’s magic circle making the following statements is immense. It adds substantially to the momentum created by Aon, WTW and by the pioneering work of the RSA. It helps move the conversation about CDC on from the whole life model applied for by Royal Mail and for the first time links CDC with the choice architecture and its governance, put in place by the FCA.
I don’t know Michael Jones but I say he and the pensions team have done those facing the “nastiest, hardest problem in finance”, a great favour, here is the article, I have put the actions in bold.
What should be forefront of the government’s list of priorities?
With the government expected to launch its first of two consultations on collective defined contribution (CDC) early next year, industry attention is demonstrably turning to CDC in decumulation and whether it could be a viable alternative to drawdown at retirement by turning pension pots into income for life.
Existing legislation covers employer-run CDC schemes (single or multiple employers part of the same corporate group) but so far, only Royal Mail have taken up the mantle. The Royal Mail model of CDC is a bespoke design and a “DB Light” model (there is a DB section to provide retirement lump sums in conjunction with the CDC section and provision for death benefits).
It remains to be seen how many corporates will seek to emulate Royal Mail and establish their own CDC scheme under the existing legislation. But there is a potential sweet spot for CDC as a retirement solution: it could provide members with higher income in retirement than an insured annuity; it enables longer-term investment in growth-seeking assets which suits the government’s agenda for DC pensions; and unlike drawdown, it does not require individuals to make financial decisions throughout their retirement and plan their income drawdown. See our autumn edition of DC Practical Notes, summer edition of DC Practical Notes and spring edition of DC Practical Notes for further commentary.
But for all these potential advantages, there are still significant obstacles for the government to address in the next phase of roll out. This will be crucial to the future of CDC. It will determine whether CDC is a niche solution for the few or becomes a widespread retirement solution for many.
In our view, the government should focus on five strategic areas:
1. CDC and retail
To date, the government’s focus has been on CDC for the occupational pension scheme sector. CDC requires an annual valuation, adjustment of benefits and robustness of governance which complements the discretionary decision-making of trust-based schemes under the remit of the Pensions Regulator (TPR).
By focussing on these schemes, however, the government risks narrowing the marketplace considerably – there are very few occupational pension schemes with the resources, employer base and bandwidth to offer CDC. The likely candidates are the large industry-wide schemes (e.g. USS, Railways, NEST) and commercial DC master trusts, but the majority of master trusts invest through unit-linked policies and platforms that would potentially require structural change to offer CDC.
Retail CDC is the obvious alternative market. With the FCA’s new Consumer Duty placing greater scrutiny on firms to provide good customer outcomes, there is improving governance, oversight and accountability in the retail and contract-based world and potential for Independent Governance Committees (IGCs) to provide the level of governance and oversight required to operate CDC effectively. The remit of IGCs is set to be bolstered by the FCA’s and TPR’s upcoming consultation on value for money which looks to formalise proposals for uniformity and consistency on value assessments across retail and workplace pensions. In our view, a key development will be to extend governing bodies’ assessment of value to and through retirement, which should help to improve the quality of decumulation products and reduce charges.
With a broader consumer market, there is also scale and incentive for firms to innovate and offer attractive CDC solutions. We could foresee CDC operating in a similar way to the annuity market before freedom and choice with employers providing access, support and guidance to an open CDC market as part of their HR and benefits package.
Action: the government should consider involving the FCA in its policy-making for CDC
2. Building on Royal Mail
Existing legislation is focussed solely on Royal Mail’s “DB Light” version of CDC. To make CDC work on a significant scale and attractive to providers, employers and members (all of whom will meet the cost in one form or another), there needs to be flexibility and a more simplified “DC Plus” model. This will require significant changes to the existing legislation.
The level of complexity in the “DB Light” model is significant with the annual valuation process operating in a similar way to defined benefit schemes. Trustees must prepare a viability report setting out their methodology for calculation and valuation of benefits, together with testing or modelling and an explanation of assumptions. The scheme actuary must produce a viability certificate assessing the impact of cross-subsidisation between members and there are stringent thresholds for adjustment of benefits to mitigate pensioner members suddenly facing a drop in their pensions.
Whilst we appreciate the need for robustness and financial security (particularly in a time of market volatility and recession), the starting position for CDC in decumulation should be simpler. Members already have an individual pot, which they would combine with other members’ pots in a collective pool to generate a higher CDC income than possible from their individual pots. The higher CDC income will be achieved by the collective pooling of assets; targeting higher risk-adjusted returns with greater certainty of investment horizon; and sharing of longevity risk across the collective pool (the main benefit of CDC).
From the outset, schemes would be able to model a member’s base level of annual income based on their existing DC pot with a prudent uplift commensurate with the size of the actual or prospective pool. As the collective pool of assets increases and if assets outperform, members could receive a proportionate annual uplift to benefits, in addition to an inflationary uplift.
Action: the government should require an initial conversion rate of DC to CDC which balances attractiveness with a sufficient level of prudence. The initial level of CDC income would need to be higher than an annuity from the individual DC pot readily accessible on the open market.
3. Achieving scale
One of the trickiest elements of CDC in decumulation will be to guarantee scale and enable longevity pooling from inception.
We expect providers of a CDC vehicle will need assurance from multiple employers that they intend to target CDC as their default investment strategy to ensure CDC in decumulation is commercially viable and worth the up-front costs of set-up and authorisation. We envisage providers targeting a go/no-go “scale threshold”, but to achieve this threshold, they will need to work collaboratively with their employer clients in the accumulation phase to educate members about CDC. We envisage member transfer to the CDC pool or product would be a non-advised process (similar to flexi-access drawdown), which means a robust and comprehensive programme of communications is crucial. CDC can only succeed if members understand that their income is not guaranteed.
Action: the government should consider a minimum pot size for accessing CDC, or alternatively, a scale threshold for CDC
4. Concurrent CDC and drawdown
CDC could work concurrently with, or as an alternative to, flexi-access drawdown.
CDC vehicles could potentially operate a CDC and drawdown section concurrently and allow members to split their savings between the two at retirement, allowing members to drawdown initially and then switch to CDC income in later life to mitigate issues with making difficult drawdown decisions as cognitive decline becomes a factor.
However, we consider that either members would need to: (i) select the level of funds for each option at retirement (i.e. irrevocably split their savings at retirement); or (ii) elect to transfer their CDC “share” to drawdown only if they meet strict transfer criteria through medical underwriting or a stringent medical assessment.
Otherwise, there is a real risk of selection against the scheme if members elect CDC income at retirement and then transfer their remaining CDC “share” to drawdown in later life. Without strict safeguards, we could see members taking this approach in declining health, in order to bequeath their drawdown pot on death and benefit from favourable inheritance tax treatment. In our view, there is a risk of cross-subsidy and intergenerational unfairness with transfers-out, which require careful mitigation.
Action: the government should consider how CDC and drawdown could work concurrently
5. Facilitating transition to CDC
The government should consider whether CDC in decumulation adopts a “consent/opt-in” model where schemes signpost the member to a preferred CDC solution and deploys the path of least resistance – this builds on some of the concepts proposed by the PLSA in its final recommendations for DC decumulation and utilises inertia, which underpins the success of auto-enrolment.
The alternative would be to explore an “opt-out” model – as members reach a target “transition age”, they would be automatically transferred to the CDC pool/product, unless they elect to “opt-out”. This model would require a radical overhaul of the existing transfer legislation and may lead to members wanting to transfer from the CDC section at a later date, claiming they did not choose to access it – for this reason, we do not think it is an attractive option from a policy perspective. However, it is worth considering as a way of resolving issues with members’ lack of engagement and ill-informed decisions, based on their inability or unwillingness to take financial advice.
Action: the government should consider wholesale changes to the legislative framework to enable default drawdown and CDC products
Clearly, there is a significant amount to consider at policy level. But these are exciting times and if the new CDC regime is well-considered and sufficiently flexible to allow innovation, we think CDC could be the much-needed route to adequate income in retirement.