CDC Pension Schemes: Where could they outperform alternatives?

29 Aug 2023

Many of us have read about the sophisticated actuarial models that show the expected retirement income from a collective defined contribution pension scheme is around one-third greater than that generated by a DC scheme and purchasing an annuity at retirement.

That is undoubtedly great news for consumers, and especially relevant as the Department for Work and Pensions prepares to release regulations on multi-employer CDCs this autumn, to be followed in the new year with regulations for decumulation-only CDC pension schemes.

It is also relevant during a time when the government as a whole seems to be especially focused on getting more out of existing levels of contributions as a way of solving the pension adequacy crisis.

CDC pension schemes: key sources of promised outperformance

I decided in this piece to unpick the key sources of a CDC’s promised outperformance, just to see if they stand up to scrutiny. We also need to remain cognisant of any potentially negative trade-offs, especially for consumers that transfer their pensions savings into a CDC at the point of retirement. As while joining a workplace scheme is usually an obvious recommendation, it will be the adviser’s task to explain the relative merits of the decumulation-only CDC option for those transferring from DC to decumulation CDC at retirement.

Let’s look at the sources of potential outperformance first.

Higher risk, higher return growth assets for longer

The great years of UK pensions, in which final salary schemes grew to near universal coverage, and provided generous pensions to many, were built on the culture of equity investment. And while defined benefit schemes are now mostly closed to new saving, long-term equity outperformance is not.

Vanguard Investor’s April edition showed that over the past 25 years, the FTSE All World Equity index has returned an average of 6 per cent a year over and above inflation. This is a strong, healthy return that shows that if you invested your savings in equities, your purchasing power appreciated significantly.

Conversely, Vanguard show if you had invested in cash deposits instead, while your savings would have gone up a little in nominal terms, they would have lost more than 30 per cent in terms of purchasing power.

CDCs can expect to achieve higher growth than typical DC schemes today because they can hold more risk assets for longer. By sharing risk collectively, they can hold more growth assets than would be appropriate for one individual by themselves. They can also hold these risk assets for far longer – probably all the way to the start of decumulation. By contrast, a typical DC scheme is set on a de-risking glide path over the past 10 to 15 years of a worker’s career.

Typically, from age 50, the DC schemes’ growth assets are steadily, year by year, swapped out for 'safer' assets. So, by retirement age the DC member is largely invested in safe rather than growth assets. For schemes where the trustees expect the members to cash in their pot at retirement, the safe assets will be money market funds consisting of cash or near cash assets. If the trustees expect members to buy an annuity at retirement, those safe assets will be UK gilts or AAA-rated corporate bonds.

However, in a CDC scheme, where the trustees invest with a horizon right through to the predicted eventual death of the pensioner, the de-risking happens much later. Indeed, a typical Collective Defined Contribution pension scheme could retain 100 per cent growth assets right up to retirement age, and then taper that down to safer assets over the first 20 years of retired life.

Taking the CDC scheme as a whole, this means a much higher proportion of investments will be in higher returning assets, contributing to higher retirement incomes.

Sharing of idiosyncratic mortality risk

The retirement income from a CDC pension scheme is a collective experience. So, all pensions in a specific CDC are paid from the same pool of assets. Some members will die before their life expectancy, and the remaining assets that were being held by the scheme against their liability are then used to pay the pensions of those members who live beyond their expected lifespan.

This is very different from income drawdown, where each saver consumes only their own retirement pot, a little at a time each month. Income drawdown savers that die early leave a pot behind for their estate, but they were unable to enjoy it themselves during their retirement. In contrast, every penny of a CDC scheme is used to pay someone’s retirement income, other than where lump sum death benefits have selected by the member.

By sharing the mortality risk, the CDC scheme gives all members the highest possible monthly income, whereas income drawdown savers are left with an Icarus-like problem of either not drawing enough for fear of running out or drawing too much each year for fear of not enjoying retired life to the full. This is called the ‘idiosyncratic mortality risk’. We know some people will live longer and others shorter, but death is random so you can not predict your age of death with any certainty. The CDC scheme is sharing this risk between all the scheme’s retired members.

Sharing of systemic mortality risk

A further aspect of mortality risk happens when some external intervention fundamentally changes the mortality landscape. Actuaries call this systemic risk.

This may be for the better, such as the current NHS trials of cancer-spotting tests, which could hugely improve early detection of cancers and accurately identify their location – thereby improving the life expectancy of all pensioners. Equally, systemic risk can be negative such as the Covid-19 pandemic, which sadly precipitated a large number of excess deaths, especially amongst the pensioner population.

Those buying an annuity pass this systemic risk to their insurance company as part of the price of the annuity. But insurers charge handsomely for taking this risk, because it is an unknown one, giving annuity providers little scope to lay-off this type of risk to another party, other than to pass it at a premium to yet another insurer or re-insurer. Moreover, while the insurer takes a premium from the saver for the risk that a cancer cure might mean everyone lives a little longer, if the converse applies, as with Covid, they do not pay out any more to policyholders. They simply pocket the difference as additional profit.

However, a CDC scheme retains the systemic mortality risk. No insurance premiums are paid outside the scheme and money that would have flowed as profit to an insurer’s shareholders is retained for the CDC members. The scheme will instead share the systemic mortality risk intergenerationally. If the current generation of pensioners live longer than the actuary expected, it is the next generation that pays for them.

Vice versa, if the scheme experiences excess deaths then the excess money will flow to the next generation of scheme members. The next generation of retirees should benefit in terms of their retirement income.

CDC pension income amount is not guaranteed

This may seem like a negative for CDC members, but this lack of a guarantee, unlike annuities, means that CDCs do not have to hold large capital reserves against future liabilities. Because if investments made by scheme trustees generate below expected returns, then CDC scheme trustees will balance this by declaring a lower rate of pension increase from the next valuation.

Exceptionally, if lowering the rate of pension increase does not re-balance the scheme, the trustees can reduce the amount of pension too. By contrast, the large capital reserves that annuity providers must hold in case of a period of poor investment returns have to be put up by insurers’ shareholders. Those shareholders expect double digit returns on their investment and these returns are paid for by the annuity purchaser. They are baked into the annuity price and shareholders will enjoy those returns via enhanced share dividends.

The flexibility of CDC avoids these costly reserves, leaving more money available to pay CDC members’ pensions.

Expenses

Collecitve Defined Contribution pension schemes will be run by trustees as large occupational pension schemes, either for large single employers or for smaller employers clubbing together to generate scale within a master trust, or for individuals joining collectively on their retirement.

The CDC scheme’s trustees will negotiate with all service providers, using their scale to secure low prices for servicing, investment, legal costs etc. The daily valuation, daily trading and daily cash reconciliation of DC are replaced by an annual CDC valuation.

All this gives the CDC scheme a cost advantage over retail DC pensions, such as personal pensions and self-invested personal pensions, where annual charges can be as high as 2 per cent of total funds.

CDCs target an income that increases throughout retirement

The CDC scheme targets an income that increases every year, aiming in the long term to keep pace with the cost of living. In contrast, more than 90 per cent of annuities are purchased on the basis of a level pension, which will never increase from its initial level.

In its analysis of income drawdown, the FCA found that 40 per cent of plans are being drawn down at a rate of 8 per cent a year or more today, which suggests that they will, over the long term, need to reduce rather than increase their monthly income withdrawals.

The increasing retirement incomes provided by CDC mean that more of the payments are weighted to later in life, and so the investment horizon is longer. Simple rules of cash flow management apply here, and while annuity providers, or drawdown clients using potting strategies, will be garnering up cash from day one to pay out pensions, the CDC scheme will be taking a longer view. This increases the range of investments available to the CDC, and with a wider range we can expect investment managers to deliver higher returns.

So, now that we have established where that outperformance will be coming from, in the interests of balance it is worth bringing together some of the key drawbacks of decumulation CDCs.

Drawbacks of Decumulation CDC

The CDC pension can go down

Collective Defined Contribution pension schemes target an increasing pension, and in most years the results of the annual valuation will be to adjust the rate of increase.

If a scheme that had been targeting a 3 per cent annual pension increase has a bad year and investment values fall by, say, 15 per cent, its trustees might declare a lower annual increase of 2 per cent for future years. Pensions would still be increasing, but more slowly than before. It is only extreme adverse experience that would lead to a reduction in nominal levels of benefit.

It might be appropriate for a CDC scheme to ask a prospective member, 'how would you cope if your pension income was reduced by 10 per cent?' Those who cannot tolerate this level of loss might be best advised not to choose a CDC to fund their retirement. However, by the same token it might also be appropriate to ask those contemplating buying a level annuity at retirement how they intend to cope over the duration of their retirement with increases in the price of the goods and services they currently enjoy.

Those who die early cross-subsidise those who die later

CDC pensions are expressed as a lifelong income and that income stops on death. In contrast, DC pensions are expressed as a pot of money, and under income drawdown any part of an individual pension pot that has not been used by the member is returned to their estate on death.

While at first sight this might appear to be a disadvantage for CDC, there is in fact scope to set an appropriate level of death benefits within a CDC pension scheme. For example, upon death of the member, their CDC pension can continue, perhaps at a reduced rate to meet the needs of a surviving spouse or dependent partner.

In addition, a lump sum can be payable on death before retirement, or in the first few years of retirement, to avoid the perceived unfairness of a member having saved for many years and then receiving a pension for a very few years before early death. However, those who have saved up far more in their pension than they expect to spend over their retirement, and who are keen to leave any excess pension money to their children and/or grandchildren on death, might be best advised not to choose a decumulation CDC.

Trustees choose investments, not members

It has become common for DC schemes to offer members a range of investment funds to choose from. Some may choose elevated risk strategies such as Chinese or Russian equities and prosper if their choices fare well. Others may opt for safety, choosing funds that target low volatility. However, members of a CDC scheme have no choice; the trustees, in conjunction with their professional investment advisers, will select all CDC investments.

If clients want to pick their own stocks, screen out ‘nasties’ like tobacco and alcohol, or follow a more aggressive carbon neutral strategy than the Paris commitments the trustees may be targeting, then they will have to stay in DC and drawdown to do so.

Although all CDC assets are pooled together, an ingenious part of the CDC design smooths the member experience through the mechanism of adjusting the annual pension increase. While for all members a change from say 3 per cent to 2 per cent annual increase seems small, it represents a rather bigger change for younger members than older members.

In this way, the CDC pension scheme automatically pools the risks intergenerationally, meaning that younger members will be exposed to, and benefit from, rather more of the higher volatility investments than older members, even though this exposure is largely unseen behind the calm exterior.

In conclusion, the arrangement of pensions in a collectively pooled manner is a much more efficient framework that translates into a projected one-third or more higher retirement income than current DC plans. It can not always be better for everyone, but the CDC’s scheme design has smart features that ameliorate the core potential downsides.

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