What is it the British pension savers want, and until now have been denied in private sector pensions?
According to UK pensions minister Laura Trott, last week saw a “landmark moment” for British Pensions. She was highlighting the authorisation of the first collective defined contribution (CDC) scheme in Britain.
She went on: “This is just the beginning. We have seen the positive effect of these schemes in other countries and our plans to extend our CDC framework will enable more pensioner savers to achieve the retirements they want.”
So, what is it the British pension savers want, and until now have been denied in private sector pensions? The answer to that is pretty simple; they want a cost-effective way of saving for a pension which will last them until the day they die.
Currently that is not what they get from DC savings. Instead, they are presented with a cheque when they retire. That money can be used to buy an annuity – and hence secure an income for life. But annuities are expensive. Studies suggest CDC would offer pensions much higher than DC savings an annuity purchase.
Alternatively, pensioners can draw down from their pension pot. But if they don’t know how long they will live, they don’t know how much they can afford to spend each year.
Yet two-thirds of the financial wealth of British households is saved for private pensions. We therefore have a system which is highly inefficient, at creating an income for life, and in aggregate that costs a lot.
On a conservative estimate, if the British system matched best practice in Holland, Canada or Denmark (where CDC style collective-income-for-life pensions are common) they would have a 30% higher retirement income. A 30% uplift on two thirds of Britain’s household financial assets certainly justifies Trott’s comments on this being a milestone. It sounds almost too good to be true.
So readers of IPE, who are pension and investment professionals, will want to reflect on where that 30% uplift comes from. It starts by targeting an income which lasts pensioners from the time they retire until the time they die. Therefore, the central question in a pension system is how to find the most effective way to provide that lifetime income.
The answer to that has to do with design. As we noted, most private sector pensions in the UK today aren’t really pensions. DC plans, are tax advantaged savings which pay a cash sum when you retire.
You can buy an annuity with that money, which will give a lifetime income. But the terms and conditions necessary to make annuities safe, combined with low interest rates, mean they are very expensive.
An annuity typically invests in very safe, very low-interest bonds, the insurer has to set aside reserves in case its calculations are wrong (it needs to make a profit) and so the saver gets a poor pension, which often has no protection against inflation.
Furthermore, the cost of an annuity varies a lot over time, which makes it difficult to plan your retirement.
Because of the high cost of annuities, and despite that fact that people want a lifetime income, many prefer to draw down from their pot of savings and invest it more appropriately. If they do, and they have a low-cost fund manager, and they know they will die at average life expectancy, then they will replicate CDC, and most likely have an income in retirement much higher than the annuity. A 2% higher return each year will give them a pension income that is about 20% higher; 3% would make it 30% higher.
The problem is that since people do not know when they will die, they don’t know how much they can afford to draw down each year, so drawdown doesn’t provide an effective income for life.
This is solved if people can save into and draw down from a common pot, a CDC plan. Because although we don’t know when any individual will die, we can estimate the average life span, and pay benefits on that basis. For those who die young, their funds will help create the income for those who live to a ripe old age. But everyone will know they have an income until the day they die.
CDC has several advantages, and, according to a variety of studies, some commissioned by the government, others undertaken by leading universities, actuaries and think tanks, by sharing “longevity risk” over a lifetime and investing sensibly, it will provide an income 30-40% higher than an individual DC pension.
The key point is this: CDC is designed cost effectively to ensure that people do not run out of money if they live to an old age. The scale of the benefit is vast. According to the Office for National Statistics, about £3trn in capital has been set aside by pension savers. A 30% uptick in productivity would, over time, have a capital value of nearly £1trn.
Until last year, however, collective pension saving was not allowed in the UK unless payments were guaranteed by the employer sponsoring the pension plan. With little publicity, and with full cross-party support, that has now changed and Royal Mail has been authorised to launch the first CDC pension. Its plan alone will serve around 140,000 people.
The next step is for other employers to adopt the model Royal Mail is using and to allow it to be provided for multiple employers. Again, and with full cross-party support, that is exactly what the government is proposing to do, with a consultation on multi-employer pensions just completed.
But let’s be careful. CDC has big advantages, but it also has downsides which need to be managed. One very significant one is that pensions in payment may have to be reduced if there is a financial crisis. In Holland, pensions were reduced on average by 2% following the global financial crisis. So good communication is vital – as is good governance and regulation.
The benefits of CDC will take many years to bear fruit, since by their nature pensions last for decades. But the foundations which are being laid today should be of profound interest to any chief executive, finance or HR director who wants to get value for the pension to which their company is contributing. They should be of even more interest to trade unionists and to workforce representatives who want to ensure a decent retirement for their members.
Trott’s predecessor was Guy Opperman. He declared that CDC pensions could “transform the UK pensions landscape and deliver better retirement outcomes for millions of pension savers”. If companies and workers take advantage of the new rules, they can do precisely that. So the announcement by Royal Mail, is indeed a milestone.
David Pitt-Watson is co-chair of the CDC Forum of the Royal Society of Arts. Hari Mann, fellow co-chair, contributed to this article