The experience of collective defined schemes in the Netherlands illustrates shortcomings
The UK Parliament’s Work and Pensions Committee recently called for submissions to its enquiry into ‘defined ambition’ schemes, also known as collective defined contribution (CDC) schemes.
Sometimes referred to as the ‘third way’ for pension funds, CDC has been put forward as an alternative to traditional defined contribution (DC) schemes. However, part of the challenge in evaluating the effectiveness of CDC comes from how it is defined. If you ask 10 people what CDC is, you are likely to get at least 11 different definitions.
For the Work and Pensions Committee, however, CDC is an approach that combines the assets of scheme members into one pot. This collective pot includes members saving for retirement as well as those receiving retirement incomes.
But it isn’t quite that simple. The means by which assets can be pooled, the method for allocating risk, the distribution of realised outcomes, and compatibility with freedom and choice are just some of the issues that need to be addressed if CDC schemes are to operate effectively. Rather than collective DC, complex DC might be a better title.
There are lessons to be learned from other countries. CDC schemes emerged in the Netherlands in the early 2000s and much of the subsequent time has been spent debating how the system should work. There have been multiple regulatory regime changes during this period and the debate continues to rumble on. The main point of contention is that the system has not lived up to its promises, leading to a loss of trust in pensions as a whole.
We reviewed the increases to pensions in the five largest Dutch schemes, representing over half the value of the Dutch pension system, over the past decade (see table).
These CDC schemes have failed to deliver an inflation-linked income to retirees over this period, which has resulted in cuts to retirees’ real income. Retirees are likely to expect their incomes to at least be guaranteed in nominal terms. However, the nominal amounts being paid experienced cuts at three of the schemes.
The five schemes retained material exposure to interest rate risk over the period. The fall in interest rates during that time has had a serious impact on these schemes’ ability to grant increases that keep up with inflation.
So what can be done? Traditional DC has been characterised by a focus on pot size and the total return on assets invested. However, the link between pot size and an inflation-linked income in retirement is not a fixed relationship. Consequently, a change in perspective from pot size to income is required.
Benchmarking DC strategies, whether traditional or CDC, against the lifetime inflation-linked income in retirement is the first step in delivering this objective. Having a clear and relevant benchmark allows investment and risk management decisions to be taken within the right context. This approach has been successfully applied to UK DB schemes for more than a decade.
Annuities are a well-known, if not necessarily popular, approach to ensuring that a retiree’s savings last for life, but there are other options available to prevent retirees from running out of savings in retirement, such as risk pooling.
Traditional DC schemes have access to the same investment opportunities as CDC schemes, so neither has an advantage in this area.
Similarly, the benefits of economies of scale are not the sole preserve of a particular type of pension arrangement.
Is a new way required?
While we are supportive of the objective of delivering an index-linked pension, it is not necessary to create a new regulatory regime to achieve this objective.
Index-linked pensions for life can be efficiently delivered within the existing regulatory framework. The ever-changing regulatory environment is often cited as one of the issues undermining trust in UK pensions. Why, then, look to introduce a whole new regime that would add further regulatory complexity at a time when UK pensions would benefit from simplification?
Based on our experience of the Dutch market, where CDC has been implemented, it is clear that savers do not fully understand the income ambition offered by CDC, mistakenly believing income to be guaranteed.
We must change the way success is measured, moving from a focus on pot size to a focus on the income being built up.
Benchmarking progress against income gives savers, and those acting on the savers’ behalf, such as trustees or independent governance committees, a clear measure of progress towards the end goal.
Managing savers’ assets against this benchmark, as has been successfully implemented by DB schemes using techniques such as liability-driven investment, also increases the likelihood of the lifetime inflation-linked income in retirement being delivered .
While we should learn from the Dutch, let’s not go Dutch on this occasion.
Ralph Frank is head of DC pensions at Cardano
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Collective DC: Let's not go Dutch