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Why are providers developing simpler retirement income solutions?
Retirement is extraordinarily complex for members. At the same time as navigating profound changes in their personal lives, they must also manage a myriad of financial decisions: where to invest, when to take income or cash, how much to withdraw, how the state pension fits in, and how to avoid unintended consequences, such as triggering higher tax rates or losing entitlement to state benefits.
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It’s no surprise that Nobel Prize–winning economist Professor William F. Sharpe described the challenge of turning a pot of money into retirement income as “the nastiest, hardest problem in finance”. This is why there is demand for simpler income options at retirement.
In our view, a solution that offers a retirement income, albeit an income that is not protected, may be appealing from this perspective.
What advantages might Collective Defined Contribution schemes (CDC) offer
for members?
One key advantage is that members don’t have to make complex decisions themselves. While this may remove some flexibility, it helps to simplify decisions, making pensions easier to engage with.
CDC schemes also tend to invest more heavily in assets with higher expected returns, like equities. This may boost expected outcomes for members. It incurs greater investment return volatility, but the schemes use mechanisms to help smooth pension payments in the short term.
Another advantage of CDC is longevity pooling. Members share the risk of living longer than expected, which may improve expected outcomes. While annuities available in DC also hedge longevity risk, they don’t allow individuals to pursue higher expected returns at the same time.
What are the potential risks for providers, employers and members?
As mentioned, CDC schemes invest aggressively which means higher expected returns and higher expected outcomes. However, there is no escaping that this incurs greater investment risk. CDC schemes use mechanisms to smooth pension payments in the short term but the higher investment risk doesn’t disappear – rather it is effectively transferred to the longer term i.e. from older to younger members. This results from how CDC schemes adjust expected benefits when things don’t go as expected. They typically change the indexation rate (the expected rate of pension increases) rather than adjusting all expected payments by the same proportion.
More generally, a concern with CDC is potential intergenerational unfairness. A key question we’ve researched is in what ways could younger members in CDC schemes be disadvantaged and how could this be addressed to improve fairness?
There are different notions of fairness, so we need to be clear by what we mean in this context. In our view, a scheme is fair if the present value of benefits awarded to a member – calculated with an appropriate risk-adjusted discount rate – equals the size of the contribution made at that time. Similar ideas apply to other exchanges, such as transfers in or out.
In theory, any unfairness (as so defined) can be addressed by adjusting the terms of exchange of money for expected benefits. If priced correctly, the exchange should be fair.
Some aspects are easier to price than others. A very important aspect to capture to avoid unfairness is the time value of money – the fact that money today is worth more than the same expected amount in the future, because of its expected return. So, in theory, the accrual should be cheaper for younger members than older ones — flat accruals work against this and risk creating unfair outcomes.
The investment risk transfer mentioned above adds another layer. Younger members are exposed to more uncertainty, so accrual ideally should reflect that through appropriate, risk-adjusted assumptions. This adds some complication, but is manageable using standard techniques, providing the scheme continues to attract new members over time.
That brings us to another risk – new entrants to the scheme may slow or stop. If that happens then younger members lose the ability to pass risk on as they age. This risk is harder to gauge.
‘Assumption uncertainty’ is yet another risk to consider. If longevity is underestimated, for example, then younger members may end up bearing the cost.
This all said, we’re keen to stress that ‘fairness’ (as we define it) is not the only consideration in scheme design. Simplicity matters too, especially from a member perspective.
Other things to bear in mind include that longevity pooling reduces death benefits, and that CDC does not offer members flexibility. CDC schemes also face practical challenges. They require strong governance, careful actuarial oversight and sufficient scale. While CDC schemes may feel simpler for members, they are generally more complex and costly to run than DC schemes.
How might a retirement-only CDC work?
Retirement-only CDC (RCDC) is similar to whole-of-life but starts from retirement. In exchange for a lump sum an expected (not guaranteed) pension is awarded.
As the duration of RCDC schemes is shorter than whole-of-life, the method of adjusting benefits through the indexation rate is less effective at stabilising short-term moves. This means that the scheme is unlikely to be able to invest as aggressively as a whole-of-life scheme, so expected uplifts may be more modest than whole-of-life. Like whole-of-life CDC, stabilisation of the short term potentially comes at the expense of greater long-run uncertainty in pension levels.
The ability to pool longevity risk while investing in growth assets remains a key advantage. Challenges include scale and costs, as mentioned above, and the extent to which different members are offered different terms based on indications of their longevity, for example postcode, biological sex or medical history.
Is L&G looking to develop a CDC solution?
We are exploring the potential development of an RCDC solution. Our priority is to help secure better retirement outcomes for our DC members. CDC schemes pose a powerful opportunity to seek key benefits for certain cohorts. By managing investments collectively and sharing longevity risk, CDC schemes have the potential to provide members with a higher expected retirement income, with simpler decision making.
There are of course multiple factors to carefully consider before launching a solution. This includes how regulations evolve and meeting Consumer Duty requirements, client demand, and commercial factors. We’re committed to working with clients, regulators, and industry stakeholders to shape solutions that can enhance retirement options and outcomes for members, driving innovation in pensions.
Ultimately, it depends on whether it’s the best option for our DC members – we’re continuing to monitor and evaluate and will wait for the final regulatory framework for RCDC.
What other solutions might be seen when it comes to delivering default retirement options. How does CDC differ from longevity risk solutions, for example?
A CDC scheme is a type of pension plan structure that includes longevity pooling but only as one of its features. In contrast, longevity risk solutions are risk management instruments rather than plan designs. They can be used to manage the risk that people live longer than expected. This can include annuities that can hedge at the individual level, but also reinsurance and longevity swaps, which can hedge the experience of a group. CDC schemes could use longevity swaps to help manage systemic longevity risk.
We’re developing a DC decumulation solution that involves spending from a drawdown fund followed by later-life annuitisation. We’ve developed important intellectual property concerning the investment strategy and an innovative way to guide spending that aims to avoid cliff edges in consumption. The ‘L&G Guided Income’ solution is likely to appeal to members that value flexibility, but appreciate a degree of guidance on investment and spending decisions.
When might we see these new retirement options in the workplace market?
The timing of new options will be influenced by the government’s proposed roadmap for introducing RCDC and guided retirement solutions. While innovation can happen now outside of RCDC, the regulations on guided retirement will define the parameters, opportunities and potential constraints that such solutions will need to operate under, if they are to be used as defaults.
Consultation on the regulations for RCDC and guided retirement are expected to be published during the first half of this year, while applications for RCDC authorisations are tabled to start early in 2028.
