Through pooling of longevity risk, and adopting a higher return-seeking investment strategy, CDC can offer a higher expected income for life than alternative approaches.

John’s praise for CDC is that it takes investment risk  and pools longevity risk . This praise sets CDC up for criticism.

CDC can go for growth without taking investment risk. Over time a long term investment strategy will outperform liability driven investments which cannot target growth. Anything that targets annuity buy out has not got the infinite investment horizon of an open collective scheme. Let’s remember the problem of closed pension schemes

As for pooling of longevity, less is deducted when insurance or reinsurance is not in place but the pooling only works well if there is scale so CDC is a scheme that works so long as it is popular. If it can be strangled at birth, a CDC scheme can never prove that it will work and that is what has happened since it was introduced in 2014 by Steve Webb and discussed by Derek Benstead (the author of the above picture) since the days of stakeholder pensions.

A more cogent criticism  of CDC is that it swaps flexibility and choice for – well – a pension.

We have been seeing transfers from pensions to pots since the late 1980s and moving money from pots to pensions has not been popular with employers , advisers or with DC workplace schemes.

These are the rabbit punches to soften the reader up . CDC can give us up to 60% more than what your DC pot will show you on your pension dashboard but that’s meaningless because UK UMES CDC just doesn’t stack up as L&G are keen to tell us

CDC schemes share similarities with defined benefit (DB) schemes, but don’t receive deficit contributions from sponsors. Unlike Dutch CDC schemes, UK CDC schemes also can’t use buffers – liabilities must always match assets. As such, benefits must be adjusted regularly to maintain balance.

As my friend Derek Benstead reminds me, CDC’s pricing will always be out because assets and liabilities will only tally coincidentally and then but for a moment! There’s no buffer as insurers hold when operating  with-profits and trustees hold to guarantee defined benefits And there’s no safety belt like the PPF provides DB or FSMS provides annuities.

But worst of all – here’s something you didn’t know, I didn’t know and the people who are working on  “dynamic pricing” for  multi-employer schemes can’t possibly know because they are not one of Britain’s largest insurers (hmm)

The “something” (according to John’s article) is that CDC is vulnerable to falls in the markets its funds are invested in.

How benefits are adjusted matters. For example, if scheme assets fall by 18% relative to liabilities, overall benefits must be reduced by the same proportion, but there are different ways this can be achieved. There are two main approaches:

• Scaling approach: All expected benefits payments are cut by 18%, with no change to the indexation rate of the scheme (the rate pensions are increased each year).

• Indexation approach: The rate of benefit increases (indexation) is reduced. For a scheme with a 20-year duration, reducing indexation from 3% to 2% per year results in an overall liability reduction of 18%. The impacts are much greater for longer-dated cashflows as you can see below:

The reason nobody knows this is because it isn’t true. A scheme may see its assets fall 18% in a year but it does not have to pay 18% less either in a cut in benefits for a year or  through 18 years of lower increases.

That’s because the scheme will have an expected growth rate that will anticipate a year or two of horrible returns as well as a year or two of huge returns. Let’s say the average return expected is 8%, they will have to get back the 18% plus the 8% positive return which never happened. There will have to be somewhere in the future, something wonderful like mid twenties returns. But we do get market returns that high, just as we do get market falls that dismal.

This is what happens if you don’t get the bounce, which is never!

What goes down, goes up!

To suppose that people will be down 25% for one year’s market fall of 18% is fine if we are talking a single payment, but that’s not what happens when saving into a UMES CDC pensions, they get this bad news balanced with good news in better years  and overall people will get target increases (typically inflation linked) every year.

They may get more or less pension for their money if there is surplus fund from outperformance and less pension for their contribution when the scheme is behind on funding and it will very badly be accurately balanced. But this form of dynamic pricing is what is going to be available for multi-employer pension schemes and certain occupations like bus drivers, religious workers and those who work in housing associations may find themselves in a CDC pension that allows them to move from one employer to another while staying in the same sort of work.

As for the assumption that they will be caught out by contributing in a year where money goes down 18%, they can feel happy that money goes down but it also goes up and pounds cost averaging applies! As long as the average return is close to the assumptions made by the scheme, the benefits will be as projected, even if there are some rocky years mingled in with the good.

Is the youngster discriminated against?

John Southall repeats the arguments made against Royal Mail’s CDC scheme

The chart illustrates the greater downside risk for younger members. They also have more upside risk, but it isn’t the case that “more downside is OK because there is more upside”. If members are exposed to more investment risk, they ideally should be rewarded with a commensurately higher investment risk premium.

In a CDC scheme, everybody is in the same fund (a collective fund) and there is not more upside for the young than the old.  This is DC thinking where individuals face there final years on their own (not collectively). When young, members of a CDC scheme get a lot of pension for their contribution and as they get close to retirement they get less pension. This takes into account the investment they are making of their money which they lose for a lot longer as a youngster. It is not a question of rewarding people with an investment return any more than it is right to make people pay for a bad year’s return on the fund.

In John Southall’s article, the first of his four remedies to set CDC right is “(1) Time is Money”. This is already being considered by actuaries using dynamic pricing and this is a development for multi-employer schemes.

The second point “(2) Investment risk transfer” is one for me to hand to actuaries to chew over but I take the difference between scale and increase to be the price conversion (scale) and the revaluation of the promise (increase) and this simply gives the scheme actuary the opportunity to dynamically adjust the amount of pensions that will pay to each member depending on their time in the scheme and the market conditions they’ve experienced. Of course it won’t be 100% fair (like a scheme not being 100% balanced – surplus v deficit) but it should be fair enough.

The third point is that CDC works when new members join and it is not closed to youngsters. There is a lot in the CDC code about “continuity” and what happens if the closure of the scheme is triggered. Basically the scheme can merge with an open one, put a problem right or in the worst case – wind up.  I do not see CDC schemes setting out to fail , but nor do I think that no CDC will fail. If some master trusts have had to merge, then so will CDCs, most will choose to merge just as most DC master trusts which have been consolidated chose to be consolidated. Why should CDC close en masse? Why should CDC pensioners have a new proprietor? Why should the regulator allow a CDC scheme to get into trouble that it could not get out of?

The fourth and final point raised by John Southall is that trust needs to be built for the future. To be honest, I think that most of the lack of trust in CDC has been created by the ABI, which L&G rejoined last week.

CDC schemes offer attractive features, but their long-term success may depend on whether intergenerational fairness is treated as a core design consideration rather than an afterthought.

To suppose that those who have been working on CDC for over a quarter of a century are not aware of the potential of unfairness is crazy. More time has been devoted to the question of creating fairness than just about anything else. That is because there is so much good to be shared and those who love CDC (I am one) do not want to foul things up by getting fairness wrong.

The UMES route is the least risky for unfairness to occur as time allows the horrors of short term market turbulence to create unfairness. There is work being done on that but right now the work to make UMES whole of life fair, is pretty well done.

My hopes for my pension are linked to L&G!

I have approached L&G to see if they would like to join with a Pensions Mutual I and my colleagues are setting up and they have said “no thank you”. This is not a problem, I am an L&G DC saver and I hope that L&G and me will stay friends, I’d rather a CDC style pension than an annuity or guided retirement with flex and fix into an annuity.  But as a relatively dynamic 64 year old, I have no problem in waiting a couple of years till I am ready to pack it in!