When it comes to accessing DC pensions, the onus passes to individuals. Lump sums do not provide long-term income; insured annuities do, but data shows that perceived high expense lead few to purchase them. And so, drawdown is often the de facto choice individuals make at retirement.
A CDC decumulation product would allow the purchase of an income payable for retired life, at a variable rate. This would be similar to an insured annuity but with a crucial difference – there would be no guarantee. Instead, the CDC scheme would invest more heavily in growth assets, especially in the earlier years of retirement, and would collectively share risk across members and over time, with the expectation of providing a higher income than could be provided by an annuity.
We estimate this greater investment freedom could lead to 50 per cent higher expected retirement income than an insured annuity.
While an individual could try to mirror the investment strategy and initial pace of drawdown to try to match a CDC decumulation product, because they are unable to pool longevity risk they would leave themselves with a broadly 50 per cent chance of running out of money before they die.
The spreading of risk in a CDC scheme would be done by gradually adjusting the level of increase applied to each pensioner’s income each year. For example, an individual might buy a CDC pension initially targeting CPI increases, and if assets outperform by 10 per cent in a year, this could lead to an increase of CPI +1 per cent in that year and to be targeted in all future years, subject to any readjustments in future. Conversely if assets underperform, increases could be reduced or income could even be cut. Adjustments would also need to be made for changes in member lifespans versus original expectations. These assessments would be made by trustees having received actuarial advice.
While this form of investment risk spreading facilitates cross-subsidies between one generation and the next, in the way that it ‘smooths out’ good or bad luck with investment markets over time, these cross subsidies are typically limited for two reasons. Firstly, a decumulation only product would have an older average member than a whole of life CDC scheme and so at a particular time would spread experience over just one generation of pensioners. For a new pensioner buying a CDC pension, the purchase terms would be set so that the expected long-term value of CDC income equals the purchase price, so that past experience does not affect the income of the next generation of pensioners.
Secondly, we suggest that the investment strategy of a CDC scheme should require derisking as the pensioner membership ages to ensure it remains sustainable – ie retaining an acceptable level of variability of income levels – if the flow of new joiners reduces or the scheme closes. This means that older members’ incomes are supported by lower risk assets, which marries up with the fact that they are exposed to less variability of future income levels (ie because changes to pension increases have less of an impact on them). This can be designed in such a way that the investment risk exposure to each individual is close to that if they were to invest the money in the same way themselves.
What this risk sharing means from an individual’s perspective is that their expected level of income is higher than if they were to purchase an insured annuity or drawdown prudently, with the chance that their money subsidises other people if they should live shorter than expected – so that, if they are the ones who live longer than expected, they continue to receive an income when they need it.
The CDC decumulation-only product could come with options at retirement. For example, different levels of target increases, with higher initial income if target increases are lower. Most insured annuities purchased these days are flat, non-increasing annuities, and so we would expect some demand for a CDC product with no target increases, but which applies some increases / reductions based on the scheme’s experience.
Another option is for a spouse’s pension payable contingently from the member’s death. We can also see appeal of a minimum pension payment period, for example of 5 years.
The challenge with CDC is the variability in the income rate. This variability will need to be explained to individuals in an unbiased way and which allows comparison between competing products, under the new regulations to be developed by DWP.