Would you invest your pension in a company that set up CDC schemes?

I’m writing under the Chatham House rule which means I can only quote myself. Yesterday I sat on a 21 person Zoom call to discuss how CDC can embrace illiquids.

Knowing most of the other 20 people in the room, I did not see anyone there that looked a chancer. Having previously placed a modest wager on the 17.15 at Bath (lost) , I suspect I was as close as anyone to someone who would take bets to boost their retirement.

Where is the business opportunity for the CDC funder?

The problem CDC has, is that there are plenty of people prepared to promote it, advise on it and regulate it , but no one prepared to do it.

Listening to yesterday’s conversation  , I suspect the risk we discussed apply more  to setting up a CDC , than to the investment of other people’s money. There is a clear path to profit from investment management, there is no path to profit from setting up CDC.

There is no point in taking risk if it is unwanted and unrewarded. Why should the entrepreneur take the risk of funding a CDC plan when there are risk-scoped projects to run ,business plans to fund , elsewhere.

The problems is that those people who have most interest in CDC are not natural risk takers. They are lawyers, actuaries and policy makers. They are not entrepreneurs, they do not go out looking for risk , they look at ways to avoid it.

An example of this came early in the meeting when someone pointed out that a CDC pension might start out paying more than an annuity but might find itself paying less than an annuity if things went wrong. Based on the assumption that we should point out all risks to those who taking them, the person making the point expressed concern that a CDC that took risks in its investment, might not provide a suitable pension for the risk-averse.

This of course is very true. As we have been taught to think safety first, most people are nervous of linking their retirements to the market. Despite this, recent figures from the FCA suggest that people the majority of people are happier with investment driven pension drawdown than any other way of spending retirement savings. I suspect this has a lot to do with “flexibility”, in other words – FAD has an ejector seat – you are strapped in –  but you do have a parachute.

CDC can only work for the general public if it can show that you can fly very fast without needing a parachute and that requires a pilot with the courage of his or her conviction.

Stepping into a steel tube and emerging 7,000 miles away some 12 hours later would  seem pretty risky to our ancestors , but we do it as a matter of course, collectively , safely and happily.

We do of course have very advanced systems of air-traffic control and aircraft safety which are designed to encourage the airline industry to build and fly more planes.

 Risk Capacity

If we believe that over the long term , an illiquid investment will make a potential return that’s worth having – ( say with an IRR of 20% +), then we need not worry about the short-term. We must accept that we cannot put all our eggs in one basket (imagine only having an investment in Thames Water) but we can stomach a 15% IRR overall , discounting the odd dud.

We might be happy with a 12% IRR on our portfolio, where a further reduction is taken to meet short term liquidity needs (eg putting part of the portfolio in short term liquid investments). The point is that if we need 12% return over the long-term (say 7% over the risk free rate) then we can set out to find the risk that can give us it.

If there is no capacity to take risk, it is either because there are no long-term assets worth investing in to get us our 20% IRR, or because we haven’t the stomach for them. Here I will point out that despite the USS pension scheme losing around £1bn on Thames Water, it had the capacity to do so, £1bn is around 1.5% of the assets. Just as my punt on the 5.15 at Bath, it was money that USS pensioners could afford to lose.

Right now, no-one would walk through the Pension Regulator’s door with a proposal to deliver a 7% real IRR , which is why there are no long term assets in CDC and why there are no CDC schemes. If the Regulator has no capacity for risk, why bother?

Risk Appetite

Risk appetite poses a different question. I had the appetite to lose £1 in the expectation of winning £3 (a 3-1 shot), because I didn’t need that £1 (capacity) but also because I knew that I could live with the consequence of losing. I would not be upset. Again, if I have 10 bets today and I end up 10% up , I’m happy, especially if I am 90% sure I wont lose more than 10%. I believe these calculations are known as “value at risk” or VAR. The general public make VAR calculations all the time, we know there’s a risk of things going wrong and we measure that risk against the reward of things going right.

We also know that there is a greater risk of doing things on our own than of doing things together. If I take my boat out on the still flooding river Thames today – on its own, I am taking more risk than going out with other boats who can help me out if things go wrong. Collective endeavour works like that. My appetite to take risk, increases when that risk is pooled and spread between others and over time. The discussions we have been having on this blog over inter-generational and cross-generational solidarity are just another way of saying this.

Funders of CDC schemes are potentially out there, if someone will take the “red boards”off the locks and allow them to move their boats about. Satisfying people’s appetite for risk is sadly now a pre-occupation confined to scammers and book makers.

Where CDC is failing

CDC needs to get out of the “what happens if things go wrong” mode – it has been stuck in for 7 years and get into the “what happens when things go write” mode, which would make it work. Beveridge would not have started the welfare state if he had focussed on the risks without considering the rewards. The same could be said of best endeavour DB schemes (which look remarkably like the Royal Mail CDC blue-print).

CDC is failing because even when the management and unions of Royal Mail agree to take collective risk on, they are stopped from doing so by silly things like charge caps that prevent them buying risky assets. These protections were put in place to stop individuals taking bad choices – not institutional investors trying to make good ones. Where people are trying to buy risk and know about VFM, let them.

They are also being held back by silly ideas like the one about annuity comparisons. Over time risky short term assets will return more, we shouldn’t worry about short-term performance tables, or risk-free comparators when we are investing long term.

Those who followed I am Maximus in the Grand National will remember that he was towards the back of the pack for the first half of the race, no one minded that when picking up their winnings.

CDC is failing because its supporters are not bold enough to promote it as “capable of taking risk”, “having a high appetite for risk” and capable of providing “winning outcomes” by converting risk to reward over time. It is a staying chaser for whom four and a half miles over gruelling fences is no obstacle to success.

A thought about CDC funders.

To set up a CDC scheme , you need to fund it, a big job. To date, I have seen no Government document that advertises the c0mmercial advantage of doing so. I can see no business plan that encourages the funder of a master trust, the sponsor of another Royal Mail or an entrepreneur wanting to set up a decumulation only plan within or without an occupational plan.

This is the bit of the project the Government and the pension industry has failed to address. Because there is no route to success and there is a great certainty of failure, especially given the risk-aversion shown by the Pensions Regulator since its formation.

If Bim wants to waken up the graveyard, perhaps he should start by setting up a model that can allow entrepreneurs to make the same long-term returns from CDC as they can on other long-term assets.

If you want a Dyson, Branson or Truell to take CDC risks, then you need to create the conditions for them to want your risk.