There is much confusion over and even resistance to the central idea of CDC pensions, – that targeted pensions may be cut if investment returns disappoint, even though this is a constant worry for the structure it is looking to improve upon, income drawdown. The promise of CDC pensions is a higher pension for members than may be achieved through traditional individual DC in most circumstances. The source of this greater return is the longer investment term. As a collective, CDC may maintain in decumulation the high equity exposures normally associated with the accumulation phase.
What’s more, members are not faced with the costs of annuity or drawdown choice. The TUC has published work, conducted by the PPI, which shows that these risks are as important as those of the savings phase.
Some observers have claimed that members will not understand the CDC offering. The member will know, in near real-time, the contribution made, the targeted pension income and the implicit investment return on their contributions, as well as the level of funding of this targeted pension.
These same observers have been calling for reserves and buffers to ‘enhance member security’, along Dutch or German lines. This makes no sense – there is only the fund and that is all members’ money. To segregate some part of that money to ‘enhance’ member protection is an extremely bizarre idea.
The cuts imposed in other countries under buffer arrangements stem in large part from another mistake, the valuation of the target liabilities by discounting them using government yields. It is performance relative to the investment returns targeted which informs us as to the sufficiency of funding and the security of the pension.
Member protection may be enhanced by risk- sharing among members. This is not the discretionary subsidy of ‘with profits’ policies, but reciprocal support among members. The benefit of support to pensioners is matched by an increase in the interests of non-pensioner members. When limited in amount and duration, it may reduce the likelihood of pension cuts to a similar order of magnitude to DB sponsor failure. The risk-sharing rules may even capture and eliminate overly generous awards made by the scheme trustees, and do so early in their lifetimes. As the tell-tale of these awards is persistent and growing deficits, the process of cutting to balance may be automated.
With no schemes yet in existence, we can only simulate what might have happened to scheme members. One set of our simulations took a random sample of members of a scheme in 1980 and examined what the outcomes might have been. If we take the case of a 63 year-old, he received his target pension in full and died aged 88. His life expectation in 1980 was 17 years. The pension was 26 per cent more per annum than could have been achieved had he taken his funds at retirement and annuitized in the market on the manner of traditional DC.
Then we have the case of 1980’s 24 year-old. He has not yet retired but has accumulated by virtue of contributions the right to 38/60ths of his final salary, which is expected to be £48,246.00, implying a pension of £38,555.80. In addition, he has earned a further 4.3 per cent from the operation of the scheme risk-sharing rules, making the total lifetime, inflation indexed pension £40,213.70 annually. These figures simulate actual DB returns of a mainstream 80/20 equity/bond scheme with no derisking, with contributions of 15 per cent until 1999 and 19 per cent thereafter.
The case of 1980’s 45 year-old is very interesting. He would have retired in 2000 with a pension of 30 per cent of his final salary, funded at 116 per cent at retirement. As there had been no call for risk-sharing support over this 1980- 2000 period, there was no supplement from this source. The excess funding was assumed to be left within the scheme. Nonetheless, in the years 2001 and 2002, and again in 2008, as markets crashed, he would have needed support as the level of funding was in deficit. This is the complement to the 4.3 per cent earned by the younger member. Drawdown, had it been available, would have been disastrous, due to the early losses. Annuitisation would have produced 71 per cent of the CDC pension income.
This article and these illustrations cover only a very small part of the range of potential design options – the consultation paper is needed to clarify which are viable in the real world.