Government plans for pensions caused ripples in the industry after the official opening of the 2014-15 UK parliamentary session. The Queen’s Speech, setting out the government’s plans for the next year, confirmed intentions to legislate for collective defined contribution (CDC) schemes, allowing a last-ditch attempt for pensions minister Steve Webb’s defined ambition agenda.
The CDC concept is already used in other European countries, mainly Denmark and the Netherlands, albeit with rather different models (see snapshots).
Any UK model is likely to be run by a single employer or grouped employers, with large DC schemes pooling investments and administration to minimise costs and share investment and longevity risks.
Such schemes are not possible under UK legislation. Under current government definitions, schemes where 100% of the risk does not lie with the member, or that make internal payments, are classed as defined benefit (DB) and fall under its regulatory regime.
However, while many industry commentators welcomed an alternative to pure-DC, it remains unclear whether collective models can embed themselves in the UK.
What will UK CDC look like?
While the Dutch model has received consistent praise from civil servants and parliamentarians, it comes with complexity the UK may not be ready for.
Danny Wilding, a partner at consultancy Barnett Waddingham, believes any initial introduction would not go as far as Dutch target benefits, and schemes would represent simpler, more efficient DC pooling systems, sharing investment risk and accessing a broader range of investment options.
This could stem the growth of the industry, and, as the UK familiarises itself, further risks could be shared in time. This idea becomes significant when taking into account the recent flexibility given to DC savers in this year’s Budget.
Some experts have questioned how the at-retirement flexibility available to DC savers could work within target CDC schemes. The full withdrawal of a saver’s pot in cash could hamper pooled investment and longevity risk, which is why the government has consulted on banning transfers from DB to DC schemes.
But Wilding and Aon Hewitt senior partner Kevin Wesbroom believe a simpler CDC model complements DC flexibility in the area of income drawdown.
The 2014 Budget retains income drawdown as a solution. Wilding and Wesbroom both believe CDC schemes could offer a cheaper and more efficient internal drawdown structure for savers.
“One central drawdown mechanism, operating for everyone, could be a lot more cost efficient,” says Wilding. “That will be one of the big attractions. It is a way of making drawdown an affordable option for a wider group of people.”
Wesbroom adds: “An alternative to annuities is the initial place where it gets traction. A CDC decumulation product could be the first we see.”
Snapshot: CDC in Denmark
ATP, an example of Danish CDC, uses a proportion of contributions from employer and employee in two different ways. Around 80% is used to purchase a deferred annuity to be paid at the agreed pension age. Each year of contribution is matched by this series of deferred annuities, allowing members to see their pension income increase over time. The level of each deferred annuity differs, depending on the rate ATP can purchase the annuity in the market in any given year of contribution. The remaining fund is collectively invested in risk assets to provide conditional future indexation, performance-dependent.
Who will use it?
Generally speaking, three options exist for CDC schemes: DB arrangements, DC schemes and the pooling of smaller schemes.
There is an expectation from some in the industry for a shift to CDC coupled with the closure of DB.
The planned 2016 introduction of CDC matches the expected closing of DB schemes triggered by the end of contracting out. Employers with DB arrangements could consider greater risk-sharing, target-benefit CDC schemes, and may face less resistance from staff over the loss of DB.
CDC models that avoid the sharing of longevity risk could become commonplace among companies recently setting up large-scale DC schemes for auto-enrolment, with any shift relatively simple. The case has also been made for DC master trusts to house CDC schemes designed with smaller employers in mind.
Wesbroom argues that Now Pensions, a master trust wholly owned by Danish CDC provider ATP, could easily convert to CDC because it already pools member investments into a single fund.
Its chief executive, Morten Nilsson, agrees with Wesbroom to an extent and says that, with consolidation, master trusts would be ideal. But he warns of the problem of risk-sharing among members.
“You need to be careful you are sharing risk with someone you should be sharing risk with,” he says. “What works quite well in Denmark and the Netherlands is schemes that are either industry-wide or based on professions. This makes sense, as lifestyles and earnings are somewhat similar.”
If Now Pensions were to offer CDC as an option to smaller employers, Nilsson says the scheme would need to ring-fence members to make it appropriate, but this immediately reduces scale. “I would want to be very careful who is sharing risk due to cross-subsidy.”
Snapshot: The Dutch model
The Dutch, or ‘target-CDC’, pension model aims for a set retirement income based on fixed contributions from both parties. Rather than members bearing investment risk, as in DC, and employers bearing longevity risk, as in DB, this is shared collectively by all members, with pooled contributions and investments. Schemes undergo regular actuarial valuations – if a shortfall exists to meet target benefits, cuts are made to pension payments or targets and reinstated once appropriate funding resumes.
Will it work?
The introduction of CDC schemes has not polarised the industry, but it has come close. Steve Webb’s ambition was for schemes to move as close to target-benefit CDCs as possible, with clear risk-sharing between employees and employers.
A host of issues must be resolved. Regarding the legal framework, law firm Slaughter & May has set out the parameters that need adjusting in the UK system, highlighting its feasibility and putting to bed doubts of an unattainable regulatory overhaul.
The issues do not stop there. Often cited as a reason for the ‘death of DB’, international accounting standards need not see CDC schemes as a balance-sheet liability. Roel Nass of LNBB, a pensions consultancy firm in the Netherlands, says this was a hot topic when the country began creating CDC schemes more than a decade ago.
Where the Dutch system has not quite mastered the proposition is the issue of fair generational risk-sharing and dealing with under-funded schemes needing to cut benefits.
“There is still no clear policy on how to deal with it,” Nass says. “A few pension funds cut benefits by the same percentage across all members, which sounds fair, but you can ask if it is. Cutting a pensioner’s income might have a different impact than on other members.”
Cuts to target benefits and to pensioner incomes did go down relatively smoothly though, with no legal action against pension funds. However, the UK system has a strong legacy of protecting accrued rights.
Wesbroom and Wilding both see it as possible for rights cuts to be palatable to the UK industry, particularly over time, as CDC settles and grows. “We will try to avoid it,” Wesbroom says, “but if things get bad there will be no other option. If you do not, it is just a fraud on younger members and not the basis of a durable system.”
However, the list does continue. Both the Dutch and Danish systems were built on industry-wide or occupational foundations and with strong union and employer backing. More importantly, they came with compulsory membership. None of this is currently viable in the UK.
The idea of basic pooling vehicles, sharing investment risks, is certainly foreseeable, as is the prospect of creating internal and efficient at-retirement options. However, whether Steve Webb’s defiantly ambitious vision for target-benefit schemes ever becomes a reality remains to be seen.