Collective defined contribution pensions are no panacea

[RobertT]

https://www.ft.com/content/10448b2c-114 ... cce2caec52

Collective defined contribution pensions are no panacea
John Ralfe argues that Britain’s CDC pensions legislation needs to be made fairer.

This is a guest post by John Ralfe, an independent pensions consultant, based on his recent lecture at Imperial College London. Ralfe argues that “Collective Defined Contribution” pensions as they currently stand are not a fix to Britain’s pensions problems as they don’t benefit the young. He suggests how CDC might be designed more fairly.


Those of you who are employed by the private sector might have noticed — perhaps with some dismay — that over the last two decades, defined benefit (DB) pension schemes, in which an employer guarantees a pension based on employees’ salary and years’ of scheme membership, have become about as common as hen’s teeth.

Such schemes have been replaced by defined contribution (DC) schemes in which there is no guaranteed pension amount — everyone has their individual pot and must manage their own longevity and investment risk. These DC schemes, therefore, can be complex to manage, easy to get wrong and, unlike DB schemes, can lead to people running out of money before they die.

So a kind of middle-ground pension scheme known as “collective defined contribution” (CDC) has been touted in recent years as a way of bridging the gap between the old, often more generous, DB schemes and the new DC schemes. But are CDC pensions really the answer?

This newspaper certainly believes they have potential, suggesting in a recent editorial that CDC could be a way of giving the young a fairer deal. Royal Mail also thinks CDC is the answer. As part of seeing off threatened strikes in 2018, the company agreed with the Communication Workers Union to replace DB and DC schemes with CDC pensions for its 140,000 staff, and spent months lobbying for new legislation, which has just become law.

But it’s worth noting that UK CDC is being introduced at the same time that the Netherlands — which set up CDC in an attempt to rescue DB, and is the CDC poster-child — is now abandoning it and moving to DC.

CDC works by setting a “target pension” amount for members each year, based on member and employer contributions. Target pensions, including pensions in payment, are not guaranteed, but move up or down every year, in line with the value of assets. Fans of these schemes claim that for the same contribution, average CDC pensions are much higher than DC, because CDC can capture the expected long-term return from holding equities, but with a lower risk of pension cuts, thanks to “inter-generational risk-sharing”. 

What is “inter-generational risk sharing” and is it fair?
If “inter-generational risk-sharing” sounds woolly, that’s because it is. Explanations of how it produces higher CDC pensions are long on arm-waving, and short on practical nuts-and-bolts.

If CDC and DC asset allocation are identical then, by definition, investment returns — and annual changes to target pensions — must also be identical. Take a CDC plan with 10,000 members and £500m assets. If assets change — up or down — by 20 per cent over a year, then target pensions also change 20 per cent, to restore balance.

Suppose instead we have 10,000 individuals each with a £50,000 DC pot, or £500m in total. If the value of their DC pot changes by 20 per cent over a year, then their “target pension” — what they can expect to draw as a pension — also changes by 20 per cent, exactly like CDC.

Can CDC schemes take more risk — namely by holding more equities than DC schemes — because they have a longer “time-horizon” than any individual saving for a pension? Royal Mail thinks so: astonishingly, its CDC plan will hold 100 per cent equities.

But since CDC target pensions are adjusted annually, their “time-horizon” is not actually “long term” at all — it is just one year. If a CDC plan, say, doubles its equity exposure, it increases both annual expected equity outperformance and the risk of annual underperformance, and therefore the risk of cuts to annual target pensions, including pensions in payment.

And anyone wanting this higher risk/return can get it directly in their own DC pot.

The Royal Mail’s claims
To ensure fairness to all members CDC must be designed so each age cohort receives a pension equal to member and employer contributions, plus investment returns — no more, no less. If a cohort receives more, it is being paid from other members’ contributions.

And this is the Royal Mail CDC’s secret — the oldest members receive more than their contributions plus returns, with the extra money paid by younger members, who end up receiving less than the the total of their contributions plus returns.

Take two members, both earning £30,000, both in the scheme for five years — so the same cash contribution — and the same target pension of 1/80th salary increased at CPI plus 1 per cent each year. One joined age 62 and is now 67, starting to draw their pension; the other joined at 22, is 27, and is now leaving Royal Mail, still 40 years away from a pension. Both of them has paid into the pension scheme for five years.

If Royal Mail achieves its assumed investment return every single year the oldster’s contributions plus investment returns run out by age 82.5 years, about five years before the average life expectancy assumed by Royal Mail.

What about the 27-year-old? Once they reach their retirement age, the five years’ worth of contributions plus assumed returns for the previous 40 years, is worth so much that it can then generate more than the annual target pension amount in investment returns alone.

The extra five years of pension paid to the oldster is pinched from the youngster, whose pension is a fraction — about one-fifth, using the Royal Mail’s assumed returns — of their contributions plus assumed returns.

A fair CDC design
The new CDC legislation is weak, allowing Royal Mail to design a CDC structure that is grotesquely unfair to younger members. Royal Mail’s “inter-generational risk-sharing” is really “inter-generational pocket-picking”. 

A fair CDC design requires four conditions:

First, all CDC plans should have to use long-term market interest rates to value target pensions — as in the Netherlands — not leave it up to each plan to decide. 

Second, annual target pensions should be age-related — higher for younger members, to reflect “the time value of money”, rather than the same for all ages, as at Royal Mail. 

Third, target pensions should be in real-inflation-linked, not nominal terms, as at Royal Mail, to discourage “money illusion”, and so that members can understand their real-inflation-linked target pensions.

Fourth, companies should also have to offer DC with the same company contribution, alongside CDC, so staff can choose which scheme to opt for. Royal Mail is closing its DC pension, forcing staff into CDC.

A fair CDC plan, meeting these conditions, would, of course, have the same overall annual returns as DC, with an identical asset allocation.

And for virtually all members, CDC has the huge disadvantage of sub-optimal asset allocation versus DC, because asset allocation is identical for all ages. Unlike DC, members cannot change their asset allocation to suit their personal risk preferences; most 30-year-olds, with a long time to drawing a pension, would want to hold more equities than, say, a 70-year-old already drawing a pension.

CDC does have the genuine advantage over DC of pooling longevity risk, and if you live longer than average you are less likely to be squeezed. But longevity insurance comes at a cost — those dying “early” pay for those dying “late”, and many people would choose DC, allowing then to leave their unused pension to family.

It is difficult to see how CDC does anything to solve the UK’s long-term pension problems. Meanwhile, the Royal Mail version — the only CDC game in town — looks like a con trick by the company and the union that will benefit only the older members, with government collaboration in the form of its half-baked CDC legislation.

[Schiff]

I've seen very similar criticism of the proposed RM CDC scheme from a financial advisor who contributes to the Money Saving Expert forum

It's not about how much you get from RM or save in salary sacrifice, it's about how much pension you end up with per Pound of your own net money going in.

The new scheme takes money that the younger members could make in investment growth and gives it to older members instead. RM money and salary sacrifice are good but eventually you're young enough for the compound growth to make you better off opting out.

The exact terms of the CDC benefit transfer will matter and that could be better. For example, if it was pay in via salary sacrifice, get RM 13.6% added then at the end of that year transfer out 100% of that value and 100% of investment performance it'd be better to do that than opt out.

Once all of the details are unambiguous it'll be possible to work out the likely best option for each age cohort.

For those just about to retire, it's easy, stay in, this scheme was designed to make you do well. For an 18 year old? Very likely that it's going to end up being better for them to opt out. We'll see.

Hopefully we'll then see unions and independent resellers targeting the relevant cohorts to help them make their individual best choices.

https://forums.moneysavingexpert.com/di ... il-pension

I have previously stated my own misgivings about the proposed new pension scheme. If financial advisors are advising people to opt out or else transfer out their share of the value in the scheme to another DC pension on a regular basis then it will make the scheme completely unviable.

It is also interesting to hear that the Netherlands have abandoned their dalliance with CDC pension schemes, which again should set alarm bells ringing.

[RobertT]

It's fair to say that John Ralfe is definitely anti CDC, as he demonstrated in this very one sided online 'lecture' a few months ago.

To even things up, here's the CWU's take on how CDC could pan out(there's a video in the link):

https://www.cwu.org/news/royal-mail-cdc ... ell-as-dc/

Latest actuarial modelling suggests the new Royal Mail CDC/DB pensions scheme could provide returns some 70 per cent higher than current Defined Contribution schemes and CDC schemes could even outperform Defined Benefit, says our DGSP Terry Pullinger in his video update to members today.

Work done by Wills Towers Watson Actuaries suggests “that the CDC scheme, on average, would produce 70 per cent more for an individual than a DC scheme and 40 per cent more, currently, than a DB scheme,” Terry explains, adding: “Now that is massive news and will certainly shake up the pension world.”

Defined benefit pensions schemes are, he reminds us, still considered “the ‘gold standard with guaranteed outcomes,” but adds that Wills Towers Watson’s performance modelling, “which has gone on ever since we created this scheme, even through the Covid period” suggests that CDC schemes “would on average actually produce a better benefit.”

Today sees the Pension Schemes Bill return to the House of Commons for its Second Reading, after which it moves into its final Stages and, providing it progresses, will then receive Royal Assent and pass into law.

Opposition to the Bill is not expected, although MPs will, no doubt, be looking carefully at the legislation and ensuring that it meets all of the usual stringent tests for new legislation.

If the progress of the Bill continues as currently scheduled – and it will become the Pension Schemes Act once it has received Her Majesty’s formal approval – Terry anticipates that the Royal Mail CDC Scheme would likely be introduced into the company “at some point next year” and “bring all our members into one ‘wage in retirement scheme.”

CWU members are warmly praised by our DGSP, who thanks them for the tremendous support” they gave to the union’s 2017 Four Pillars campaign, which was so powerful that it forced Royal Mail and the CWU into designing a new and unique on-going agreement on pensions that still offered a wage in retirement, and that led to this ground-breaking development.

Back in 2017, Royal Mail workers in the company’s DB scheme were faced with the prospect of being transferred into the DC scheme. DC schemes were once seen as the answer to reducing DB provision, but time had suggested that the outcomes for DC members would be insufficient to sustain dignity in retirement.

“So we were insistent that there must be another way,” explains Terry, “and we refused to accept that the only answer was a lump sum paid out when you retire, which wasn’t producing the best results and was insufficient to sustain people through their old age.”

Eventually, as a key aspect of the Four Pillars agreement, both the CWU and the business agreed to find a better solution, he continues: “We both got on the same page to develop the art of the possible.

“How to create such a pension scheme.”

With help and expert assistance from First Actuarial, who have aways been a great support to the CWU, and other unions, as well as Wills Towers Watson and others who support Royal Mail, the principle of a CDC scheme – a collective, shared-risk scheme – was agreed and a specific, Royal Mail CDC scheme was designed – and robustly modelled.

The scheme would replicate the old DB scheme in design, producing a wage in retirement generated via CDC and a guaranteed lump sum.

Although CDC in different forms is used in other countries, such as Canada, Denmark and the Netherlands, no scheme of its type has previously existed in the UK and so legislation was required.

“I know that it’s through the collective strength of CWU members that we’ve managed to achieve that,” insists Terry, who makes the further point that, as well as being beneficial to Royal Mail workers, the precedent set could also be “a game changer for many working people.”

For workers in other companies, “this could make a massive difference to their lives and certainly to what their retirement might look like,” he suggests, adding: “Hopefully it will encourage other employers to move away from DC and into this type of scheme, CDC, so that people can get back to having a Wage in Retirement and dignity in retirement.”

The CWU does not support any sense that CDC should replace DB schemes and believes that DB schemes are the ‘gold standard’ and will remain so until time suggests otherwise.

However, for CWU members, the modelling is excellent news that supports our view that we have found a way to give our members a genuine pensions that produces a wage in retirement.

After describing the current situation as “a big moment, a massive moment,” Terry gave a “massive thank you to all of our members who backed this union unanimously,” and that this is clear evidence that we only get what we deserve if we negotiate from a position of strength.

“It’s been a long time waiting, but we’re getting closer and closer,” he added.


Here's a link to the Willis Towers Watson findings: https://www.willistowerswatson.com/en-G ... -to-the-UK

[Woody Guthrie]

I think it could struggle because there's little appetite among other major companies for this since most of them have already abandoned or constrained their DB schemes and set up DC schemes.

In the Netherlands many of the smaller CDC schemes were forced to merge to try to find new and younger members, reduce admin costs and provide a worthwhile larger investment fund. I don't think that can/will happen here and I can see RM ending up as a pension "outlier".

I don't think there's the will amongst employers to provide anything more than the minimum and I think most people like the idea and flexibility of an individual pension "pot" on retirement even if in the long term they may lose out.

In short I think CDC is 20 years too late to find traction and unless the government decides to force companies to provide a wage in retirement pretty obsolete before it even starts, just like us to nail our colours to an already sinking ship

[david3595]

apologies if this has already been asked but as we are into July is it unlikely the CDC will begin in the next 6 months?

[RobertT]

I think it could struggle because there's little appetite among other major companies for this since most of them have already abandoned or constrained their DB schemes and set up DC schemes.

Research suggests that some employers are keen:

https://www.pensionsage.com/pa/Just-7-e ... chemes.php
https://www.pensionsage.com/pa/One-in-e ... option.php

Whether they actually go ahead and adopt CDC is another matter. DC is a lot easier!

In the Netherlands many of the smaller CDC schemes were forced to merge to try to find new and younger members, reduce admin costs and provide a worthwhile larger investment fund. I don't think that can/will happen here and I can see RM ending up as a pension "outlier".

The ability to provide multi employer CDC schemes wasn't included in the 2021 Pensions Bill, but it is something that's being looked into:

https://www.pensionsage.com/pa/Real-pot ... mes-UK.php

It's probably something that will be implemented if there's enough interest.

I don't think there's the will amongst employers to provide anything more than the minimum and I think most people like the idea and flexibility of an individual pension "pot" on retirement even if in the long term they may lose out.

The minimum pension any employer has to offer is a total 8% contribution of which at least 3% must be from them. Many offer substantially more!

Personally I think many people recognise that DB is generally always better than DC. With CDC aiming to be similar to DB, but sitting somewhere between the two.

In short I think CDC is 20 years too late to find traction and unless the government decides to force companies to provide a wage in retirement pretty obsolete before it even starts, just like us to nail our colours to an already sinking ship

It's a niche thing at the moment, but in theory at least, I think the RM scheme has potential. While I also recognise the drawbacks.
Whether other employers follow suit may well depend on the success of the RM scheme.

[RobertT]

apologies if this has already been asked but as we are into July is it unlikely the CDC will begin in the next 6 months?

The last statement from RM said they were hoping to introduce the CDC scheme in the second half of the current tax year.
But as there's still regulatory hurdles to jump over, we don't yet know if that will happen.

[Woody Guthrie]

With CDC aiming to be similar to DB

In what way Robert?
There are far more differences than similarities.

[RobertT]

With CDC aiming to be similar to DB

In what way Robert?
There are far more differences than similarities.

The benefits it aims to provide.

[Aquarius]

Of course the CWU support CDC...they are the primary supporters and movers for this scheme...to try and redress some of their awful pension decisions in the past.
I think RM could care less if our pension scheme is CDC or DC (i am sure they would have preferred DC as it would have been simpler and much quicker to bring in...in fact it would have been months ago...instead of having to go through all this palava to get the CDC scheme up and running).
The fact is we are being used as guinea pigs so the CWU can feel better about their past mistakes.
No pension scheme is perfect...but i would have at least liked the choice of going into a DC scheme without the take or leave it scenario i believe we are getting whenever the CDC scheme starts.

[Schiff]

Of course the CWU support CDC...they are the primary supporters and movers for this scheme...to try and redress some of their awful pension decisions in the past.
I think RM could care less if our pension scheme is CDC or DC (i am sure they would have preferred DC as it would have been simpler and much quicker to bring in...in fact it would have been months ago...instead of having to go through all this palava to get the CDC scheme up and running).
The fact is we are being used as guinea pigs so the CWU can feel better about their past mistakes.
No pension scheme is perfect...but i would have at least liked the choice of going into a DC scheme without the take or leave it scenario i believe we are getting whenever the CDC scheme starts.

I agree that this is all about the union. It is their pet project.

It makes no difference to RM whether they contribute a set percentage of our salary to a CDC scheme or a DC scheme. This also means that it is the union and not RM that don't want us to have the choice between CDC and DC schemes. They are meant to represent their members - not their own political "wage for life" dogma.

[RobertT]

RM closed the DB scheme to future accrual in 2018 and that's when they originally wanted everyone in the DC scheme. Which would obviously have been the easier option.

CDC was the result of the 4 Pillars negotiations and was voted for by the CWU membership. RM have also put in a lot of time and money to get the scheme up and running.
So for me, it's a joint thing!

I too think having the choice to join the DC scheme instead would be preferable, but with the ability to transfer CDC out to DC, there is still the opportunity to have what you want.

We also had a take it or leave it scenario before the final salary scheme closed in 2008.

[heapsy]

Tbh, I think it's destined to fail. A later NRA I think, also discriminates against delivery staff, as many wont make it to 67.

[RobertT]

As Dandydon says upthread, no pension scheme is perfect.

Final salary schemes are seen as 'gold plated' and the ideal, but you could say that virtually every final salary scheme up and down the country has failed. Because virtually every one of them has closed to new entrants and many have reduced their benefits for existing members by changing to career average, increasing their NRA or closing completely and going DC.
In some cases all three of those things!

You could say that DC fails to offer a pension at all, unless the individual decides to tie themselves to a poor value annuity, or else go with drawdown and potentially run out of money.

By now I think we all know what CDC is all about, and personally I think it's a genuine attempt by the CWU and RM to provide a pension scheme that gives an income for life, albeit targetted. Which in my mind is what a pension scheme should do.
While also being financially stable for the company, without the possibility of any nasty deficits to fund.

I'm not convinced CDC will do exactly what CWU/RM say it will, and equally I refuse to just look at the potential negatives. In practice a middle ground might be the reality?

Ultimately it might fail, no one knows for sure. But if it does, it'll be in good company.

[Schiff]

I'm not convinced CDC will do exactly what CWU/RM say it will, and equally I refuse to just look at the potential negatives. In practice a middle ground might be the reality?

Ultimately it might fail, no one knows for sure. But if it does, it'll be in good company.

The big problem is that if it does fail then it won't do so in the first decade or two. Those who already have a final salary element to their pension will probably do quite well out of it. It is those who are now in their 20s and 30s who have contributed for 20 years who now find that their contributions over those years are only going to produce a nominal pension when they could have had a healthy DC pension pot.

I do fear that this experiment could lead to tens of thousands of RM employees facing a less prosperous retirement than they could have had without this "innovative" pension model which really isn't needed.