Lack of Defined Ambition – CDC Pensions

Today’s post is about CDC Pensions (formerly known as Defined Ambition schemes), which have been in the news on the back of a new Parliamentary Inquiry.

Defined Ambition

We wrote about Defined Ambition (DA) pensions – now rebranded CDC or Collective Defined Contribution schemes – a few weeks ago, on the back of an FT article from Labour’s shadow pensions minister Alex Cunningham.

• It turns out this was partly because Labour have adopted CDC schemes as party policy.
• And partly because of a new parliamentary inquiry into the subject.

CDC schemes – also known as “target benefit schemes” – allow workers to pool their investment pots and share an income that depends on the underlying investment performance.

• They are not allowed in the UK but are popular in Europe, particularly Holland and Denmark.
• They are also used in Canada, and will be legal in Germany from 2018.
• They are less popular than they once were, since poor investment returns have first cut annual increases, and later scheme benefits in general.

Steve Webb announced plans for CDCs in the UK back in 2014, but the plans were shelved by Ros Altmann in 2015.

The inquiry

The government is looking for answers to the following questions:

1. Would CDC deliver tangible benefits to savers compared with other models?
2. How would a continental-style collective approach work alongside individual freedom and choice?
3. Does this risk creating extra complexity and confusion?
4. Would savers understand and trust the income ‘ambition’ offered by CDC?
5. Could seriously underfunded DB pension schemes be resolved by changing their pension contract to CDC, along Dutch lines?
6. How would this be regulated and how would the loss of DB pension promises to scheme members be addressed?
7. How would CDCs be regulated (in general)?
8. Is there appetite among employers and the UK pension industry to deliver CDC?
9. Would CDC funds have a clearer view towards investing for the long term?

A bad thing

My initial reaction was not positive, as CDC combines the worst features of existing DB and DC schemes:

1. A lack of flexibility
   • I thought that you had to take the income, whatever it was.
   • But apparently you can use drawdown – up to the funding level of the scheme, not your entitlement.
   • And you can transfer out – again up to the funding level.
2. No guarantee of performance.

I’m all for increasing the scale and efficiency of schemes, but:

1. The best way to do that is to increase contributions by scheme members, and
2. There’s no evidence that the asset management industry would pass on scale economies
3. Nor do scheme members seem particularly aware of high charges etc.

What we really need is a scheme that combines the best features of DB and DC:

• Guaranteed returns, and
• Flexibility in accessing the pot, and in choosing the underlying investments.

But the CDC concept stuck with me, and as more articles turned up on the topic, I thought I should take a closer look.

Advantages

So what are the pros of CDC / DA schemes?

There’s just one that’s relevant to workers, really:

• Scale, which should in theory lead to efficiency, lower fees and greater diversification in the underlying investments.

The government also hopes to encourage investment in UK infrastructure – and the provision of “Patient Capital” to startups – from these scaled-up schemes.

• This is of marginal benefit to the scheme members themselves.
• And it offers no advantage over a DC pension, where the beneficiary can choose what level of infrastructure exposure (of alternative asset allocation) they are comfortable with.

As evidenced by the list of questions above, the government also hopes to get rid of DB pension deficits by converting them to CDC.

• If you are ever given this option, just say no.

Disadvantages

Ok – what’s wrong with CDC? As it happens, quite a few things:

1. You have to accept the assumption that scale will lead to lower costs and better diversification for end users.
   • There are plenty of examples from the history of finance where that hasn’t happened.
2. As I said above, you’re forced to take the income on offer.
   • It’s as though the pension freedoms never happened, and we’re back to the days of annuities.
3. Except that the income is no longer guaranteed, but potentially variable.
   • At the very least, the annual increases are at risk depending on investment returns.
   • Under more serious adverse economic conditions, the entire benefits of the scheme can be redefined.
4. There’s also an intergenerational problem, in that retired members can receive more than the current natural income, in the hope that future investment returns will make up the gap.
   • This is essentially the issue that brought down DB pensions, by making them unaffordable.
5. And the potential conversion of DB schemes to CDC has its own issues:
   • Can accrued rights be removed from DB members?
   • Would trustees of an underfunded DB scheme engineer a further decline in its funding position to incentivise the member to convert to CDC?

Some observers see CBC pensions as similar to with-profits funds, which fell from grace because of a lack of transparency.

• This led to poor management, poor returns and high costs.

One criticism which is probably unjustified is the suggestion that workers would not join a scheme that was in deficit.

• But if the accumulation of benefits (or equitable interest) is in line with expectations of future returns, then past shortfalls should not matter.
• If there is no further deterioration in fund performance or employer contributions, these new members would be able to leave the scheme with their fair share.

Mark to market

One of the problems with DB schemes is that changing economic conditions lead to funding shortfalls.

• DB pots are benchmarked against government bond yields, and as these fall, the scheme will appear to have insufficient assets to deliver against it’s promises.

This can lead to funds investing in more bonds, which:

1. Have lower expected returns, cementing the existing shortfall in place, and
2. Are very risky at the bottom of the interest rate cycle, with the potential to increase any deficit as rates rise.

The  same set of circumstances also causes problems for CDC schemes.

• When expected returns (bond yields) are high, required contributions are low.
• When returns (yields) fall, higher contributions are needed for the same return.

Thus with falling interest rates, older savers in the scheme will be subsidised by later ones.

• When they retire, they will be able to draw more than they “deserve”, leaving less behind for the future retirees.

This means that in practice, each member’s individual pot will need to be calculated separately and annually in order to preserve fairness.

• This removes one of the key advantages of CDC – seamless pooling of funds.

CDB

On Henry Tapper’s blog, Con Keating (( Interestingly, “Con is on the Labour party’s pension policy group, [Henry is] a Tory party member” )) argues in favour of yet another flavour of pension – Collective Defined Benefit or CDB.

• This is a bit like DB, but without the guarantee from the employer (so like CDC).

So if the fund runs into trouble, benefits will be cut – again, as with CDC.

• If there is a surplus above 100% of the original promised return (the defined ambition), then the extra assets add security for future pensioners.

This is clearly unfair, since the older pensioners have asymmetrical risk.

• They share in the downside, but can’t profit from the upside.

This different use of a surplus appears to be the difference between CDC and CDB.

• So from the point of view of the scheme member, CDB appears to be even worse than CDC.

Con would probably argue that security of pension income has been prioritised over amount of pension income.

And on the plus side, Con would allow transfers out based on the prevailing percentage funding level.

• It is not clear to me that this is possible in CDC schemes.

When there is a deficit, the employer stumps up more cash (as now under DB) and this is shared amongst the non-pensioner members only.

• The pensioner members benefit by not having their pension payments cut (if the employer can be persuaded to make a large enough additional contribution).

Conclusions

CDCs remind me a little of the CDOs that led to the financial crash ten years ago.

• Bankers used none-too-clever maths to convince themselves (and well-remunerated ratings agencies) that mixing bad stuff with good stuff would lead to only good stuff.

As any cook or chemist knows, mixing clean and dirty just gives you lots more of the dirty stuff.

Pensions today are difficult:

• People are living longer.
• And expected returns are lower in a low-interest rate world.

The real answer is for people to work longer (by raising the retirement age) and for them to contribute more for each year that they do work.

There may be a case for pooling, but only for those with very small pension pots (say less than £30K).

• Above that level, people deserve the ability to choose their own risk level and asset allocation.

What people want is either certainty or control, and CDC provides neither.

CDCs were first mooted when many more active DB pensions existed than today.

• The default scheme – including for workplace auto-enrolment – is DC.

A DC pensions versus CDC pensions debate is just deckchairs on the Titanic.

• Since the pension freedoms made DC workable – through individual choice and control – CDC amounts to moving the chairs to the part of the deck where almost nobody wants to sit.

The government would be better off:

1. increasing workplace auto-enrolment contributions beyond the planned 8% pa to at least 15%
2. making these contributions compulsory for all workers, employed or self-employed, at all salary levels
3. creating a default, government-backed multi-asset pension investment fund, perhaps based around an UK Sovereign Wealth fund or National Investment Bank.

Until next time.