A collective approach
A look at the benefits and pitfalls of collective pensions
In July the House of Commons’ Work and Pensions Select Committee delivered the results of its enquiry into collective defined contribution schemes (CDC). It could hardly have been more positive. The report argues that CDC may offer the hope of a ‘new Beveridge’ (named after the architect of the UK’s welfare state) in pension provision; a ‘middle way’ between defined benefit (DB) pensions, and individual defined contribution (DC) savings. It is particularly encouraging of the Royal Mail/Communication Workers Union (CWU) agreement to adopt CDC.
This article examines why, after reviewing the evidence, the select committee was so positive. It considers the history of British pensions and why CDC has not already established itself. And it also looks at the pitfalls. If collective pensions can yield so much benefit, how can they go wrong?
Why collective pensions?
The British pension system was once the envy of the world. It was based on the need for a pension to offer a reliable income that would last from the time you retire until the time you die. Of course, most people do not know the date of their death. Therefore, whatever money they have saved for retirement either needs to be drawn down slowly, in case they live to an old age and run out of money, or they need to buy an annuity. But annuities are expensive. As the illustrative example shows, collective pensions, (often known as CDC), can overcome this difficulty. If what is wanted is an income in retirement the upside of CDC is considerable. For an illustrative example see panel: How CDC pensions can give better outcomes.
In the 1950s and 1960s Britain had a pension system that looked a lot like CDC. Indeed, by the 1980s it was so well funded that employers asked if they could take a ‘holiday’ on payments into the fund. Trustees agreed, only on the basis that the pension became a DB scheme – that is, that the promised pension could not be changed no matter what happened to returns and longevity.
The government then legislated to make all pensions DB. Of course, we know what happened. DB became unaffordable, and was replaced by DC – that is, a savings plan that could then be used to buy an annuity, or simply used as a savings pot from which you could draw down.
By 2015, the government realised there was a problem, and responded with the 2015 Pensions Act. This gave it powers to allow ‘defined ambition’ pensions including CDC. The Act was passed with full cross-party support. However, the secondary legislation to make it a reality has not been written. Therefore, parliament has agreed the introduction of CDC and similar pensions. The issue is to establish a regulatory framework to allow them to operate effectively.
Last year the CWU, which represents workers at Royal Mail (the postal service and delivery company), threatened to go on strike if, when the DB pension was closed, their members could not save for an income in retirement. They agreed with Royal Mail that the solution should be CDC. The government has agreed to help bring this about and that, in turn, could allow others to follow.
No-one is pretending that CDC is a perfect solution. There is no such thing as a perfect pension. So what are the pitfalls of CDC, and how can they be addressed? And what must regulators and employers do to ensure that schemes help bring trust back into the system?
• Pitfall 1: CDC pensions are not guaranteed. Unlike DB there is no requirement for the sponsor to stump up if funds are inadequate. In the Netherlands, until 2008, pensions in payment had never been reduced. Following the financial crisis they were brought down on average by 2%. Some people were furious, because they did not realise that this could happen. On the other hand, had they bought an annuity their pension might have been secure, but much lower. Therefore good communication is absolutely essential.
• Pitfall 2: CDC can be prone to intergenerational unfairness. Therefore, it is critical the actuaries are fair in their assessment of what pensions are affordable. If the actuarial estimate is over-generous, benefits will be seen to have been taken from the young to the old or vice versa. Indeed, one Dutch commentator, examining the CDC system in that country, noted that since actuarial estimates are never perfect, although all savers were better off, inevitably some were better off than others.
• Pitfall 3: CDC can have characteristics similar to ‘with-profits’ funds. CDC gives discretion to the executive of the plan about benefits paid, but also about other distributions. If that can be used against the beneficiary’s best interest, this can create problems. These are illustrated in with-profits life policies, where savers money was used by private companies to profit the sponsor. So trustees – who owe loyalty only to the members – should be in charge. Trustee governance does not mean putting private fund managers out of business, simply that they are the agents of the sponsor.
• Pitfall 4: CDC requires adequate scale. Scale is important for all pension systems. A pension investment might expect to achieve a 3-4% real return. A 1% a year charge will reduce the possible pension by 25%; 2% a year will reduce it by 50%. So it is critical for any pension system that scale is adequate to hold costs down.
• Pitfall 5: Ensuring that CDC dovetails with pension freedoms. Some have argued that although CDC works well, it might not dovetail with pension freedoms. Others argue that CDC is its perfect complement. The aim of pension freedoms was to avoid pension savers having to commit their savings to expensive annuities. What it did not do was to provide an alternative way for them to secure ‘an income from retirement until death’, save for drawdown which, as the example shows, requires ‘over-saving’.
• Pitfall 6: Commitment to purposeful pensions. Crucial to the success of CDC schemes will be the way in which policy is shaped and made in the UK. This will be greatly assisted if there is consensus among political parties, common sense regulations, constructive discussion between supporters and detractors, and a culture within the pension industry that focuses on the purpose of a pension: to create a predictable income in retirement.
So CDC does need to address these (and other) issues. But this should not prove insurmountable. After all, CDC has been the backbone of pension provision in the Netherlands for 70 years, and earned that country the reputation as having perhaps the best pension system in the world. That might help to explain why the select committee is so enthusiastic.
Hari Mann is director and David Pitt-Watson is leader of the Tomorrow’s Investor project at the Royal Society of Arts
How CDC pensions can provide better outcomes
Jo is saving for a pension, and wants to have enough to provide for herself from retirement until death.
She intends to retire at 65 but, of course, does not know how long she will live for. Her adviser tells her that there is only a small chance she will live beyond 100, so if she wants to be sure of an income until that time, she needs to find enough for 35 years of retirement. Jo is told that to achieve this she will need to set aside £350 per month, which will be invested in a balanced set of securities. The income secured cannot be guaranteed, but it is designed to meet the cost of a decent living in retirement. This approach is known as DC plus drawdown.
However, Jo also understands that her likely life expectancy, as with everyone else in her company, is 85. That means that if they are able to save for a pension collectively, she and her colleagues would only have to save enough for 20 years. As with any insurance, those who die young might be said to be ‘subsidising’ those who live to an old age. But everyone knows they will be provided for until the day they die. This reduces the cost a lot.
If saving for 35 years costs £350 per month, saving for 20 years might cost £200 a month. Individual savings is thus 75% more costly if the collective invests in exactly the same way as the individual drawdown would. This approach is known as CDC. Note that, unfortunately, Jo cannot access such a pension, because the government has not yet written the necessary regulations.
Instead, Jo must buy an annuity. An insurance company provides it. To be sure that the payment is ‘certain’, the insurer invests only in ‘safe’, low-return securities. In retirement, these provide a predictable income, albeit that annuities often do not offer protection against inflation. That is not a big concern today but might well be in the future.
Equally problematic, the cost of an annuity varies with the cost of ‘safe’ securities. So, before retirement, it is difficult for Jo to determine how much to save, and what to invest it in. The different investment approach in the run-up to retirement, the investment underpinning the annuity, and the cost of annuity provision (including the profits and reserves for the insurance company), all add up. As a result, Jo needs to set aside £270 a month, 35% higher than CDC. This approach is known as DC plus annuity.
Note that these figures are developed only for this simplified example. However, they are consistent with all the studies, including those commissioned by the government, which compare CDC with other types of pension provision.