CDC concerns and some answers.
This is a longer version of a blog originally posted on AgeWage.
A recent professional pensions weekly Pension Buzz survey of 100 members of its readership posed the question: “What is your main hesitancy or concern around CDC arrangements?” This blog lists the concerns expressed. It should be noted that only 37 of that original 100 offered concerns and that some of these are actually supportive of the CDC concept. We reproduce the concerns expressed verbatim in red italics below and our responses in black normal font. The order is that of the comments reported by Pension Buzz.
· 1) Members could transfer out at any time so it makes it more difficult to operate to a long term plan given there are no guarantees being given up.
It is possible to design schemes where members may transfer out at any time, however it is likely that this option will not be extended to pensioners once in payment in many scheme designs. Another idea mooted is that there could be a “test drive” window offered to members at the CDC pension receipt stage during which the member could decide to transfer out if the member did not wish to continue with a CDC pension. That test drive window could be 2-5 years from the start of the CDC pension.
It is true that there are no guarantees being given up, but it is also true that with transfers out taking place at the net asset value of a member’s beneficial interest there is no harm done to those remaining. While not giving up a guarantee, the departing member would be giving up the benefits of a collective scheme, with its risk-sharing and risk pooling. These benefits are manifold. To consider just the investment aspect, the member is foregoing benefits of scale and scope as well as the investment term. Simply put the risk-bearing capabilities of a collective far exceed those of an individual.
2) Communications need to properly explain and position this complex concept in members' minds – serious challenge.
Communication with members will be important. The draft CDC regulations place great emphasis on this, and doubtless the Regulator’s yet-to-come Code also will. It also is really not that difficult to explain – We hope to deliver a pension income of this amount and form to you in retirement but may be, due to circumstance beyond our control, unable to meet this aspiration in which case a lower pension will be paid. It is also noteworthy, that much of discussions around member communications focuses on bad outcomes, there is also the potential for there to be better member outcomes relative to what they are currently getting, and also to what the scheme intends to provide as a pension.
· A few things:
1) TPR seem hell bent on massive consolidation on all things and this is an obvious one;
I am confused by this comment – the government seems hell bent on consolidation but does the respondent believe that CDC schemes are candidates to be consolidated? CDC schemes benefit from scale and so there is no inconsistency with the consolidation agenda.
2) Government policy changes by the season so CDC could easily fall away in favour of something else;
It is of course possible that something else will find favour with the government in the future, but there is nothing currently envisaged which would be obviously superior to CDC. Moreover, the Pension Schemes Act 2021 (PSA 2021) has provisions that a CDC scheme may be converted to DC if government attempts to increase the obligations of employers.
3) this was being pushed mainly by one consultancy only and there are many others that have significant concerns;
This is not factually accurate. There are numerous consultancies which have supported the introduction of CDC schemes and would like further expansion of the rather limited single/connected employer permissions of PSA 2021 to encompass multi-employer and master-trust type arrangements. Given those developments, it should also be noted that expansion to a non-occupational setting could also prove attractive – for example to affinity groups – TV film cameramen, butterfly collectors, Which subscribers or whatever.
4) It hasn't been that successful in the Netherlands where that's held up as being the primary example of CDC systems.
The example of the Netherlands is of how NOT to do it. The Netherlands provides a learning opportunity to avoid problems The recognition that Dutch DB had no enforceable debt on employers resulted in a rebranding to CDC, but with the consequences either not explained to members or inadequately described. For many decades, these schemes had been presented to members as DB. The regulation of CDC in the Netherlands has its roots in the earlier DB supervisory regime, from which, inappropriately, it is little changed.
· Any arrangement that adds a liability or trail cost, however small it is initially perceived to be, must be unattractive. I see CDC as stop gap temporary fudge for those that do are (sic) unable to make a switch from DB to DC. No rational employer is going to switch from DC to CDC.
Most CDC schemes can be expected to bear the costs of authorisation and of provisions for future wind-up expenses. But when these costs serve to reduce the risks of a CDC scheme relative to DC or other arrangements, they are valuable to members. They also become valuable to employers as a recruitment and retention benefit and, for the more farsighted employers, as a more cost effective way of enabling their employees to be able to afford to retire- thereby taking legal risk of the table in respect of age discrimination claims. If the choice is between CDC and individual DC few should select individual DC. In fact, most of the research and conversations being held is with sponsors of individual DC who are considering either full transfer to CDC or offering CDC alongside their existing individual DC.
· Apart from Royal Mail no one wants them. Members won't understand them and if pension rates are ever cut there would be outrage.
The assertions here are simply that, assertions with no evidence to support them. No one is saying that a DC retirement account balance will never go down or that the amount in income drawdown from your DC retirement account will not need to be reduced. Outrage from such members seems rather muted (other than in respect of fees charged).
· Closing the door after the horse has bolted.
If this is a reference, as seems likely, to the demise of DB, this is recognition of that fact. In fact, CDC schemes should be superior to DB inasmuch as they may be considered DB schemes without the costs of guarantees. The CDC scheme will have greater resilience to both high and low interest rate scenarios and high and low inflation scenarios than a DB scheme.
The cost of the nominal DB pension guarantee in high interest rate and high inflation scenarios (assuming no guaranteed full indexation) is not particularly challenging (eg Gilt yields in excess of 10%). It is not affordable in a low QE market rigged interest rate environment when coupled with a regulatory approach that uses a short-term measurement approach as to whether the scheme can pay its pensions as and when they fall due by measuring those future obligations as at a triennial valuation date using the yield on AA rated bonds or equivalent (which have a negative real return after allowing for inflation).
· Communicating 'how it works' to employers and members.
It is new, it is a challenge. But it is not an insurmountable challenge.
· Complexity and lack of understanding by members.
This is important, but it appears that Royal Mail have achieved it with their membership.
· Freedoms at the point of retirement seem to make a mockery of the whole concept.
Offering members the option to exercise freedoms or to take an aspirational pension income is a feature which should be attractive to members. Those exercising freedoms and moving to drawdown type arrangements will be faced by the hardest problem in finance; how to manage their finances in retirement when that is clouded by uncertainties and risks on all sides. For those electing to take the aspirational income, it is no mockery – it is a rationale decision.; among other advantages the members can pool longevity risk.
If the benefit design offers, like a DB scheme, a guarantee period (but in CDC not a guaranteed amount- it will fluctuate like the continuing CDC pension) and a survivor’s benefit, that can address (as it does in DB) the member’s understandable concern of dying shortly after starting to receive the CDC pension.
· Front end cost to set up and viability until scale is achieved + on a standalone basis risk for the Employer in the future to political risk of imposing costs on the employer to fil any funding shortfalls Vs expectations created.
A portmanteau of concerns. Authorisation and other costs will need to be recovered from the scheme fund over time unless met by the employer/scheme sponsors.
Viability until scale is achieved is also a valid concern, but most of the costs of such failure will fall upon the sponsors of the scheme. Such failure would also indicate a failure of the Pensions Regulator in the authorisation process.
The process of explaining, persuading and then legislating for CDC schemes made it clear that the CDC pension could go up or down and that the employer was not on the hook to make good an shortfall between actual investment return and assumed investment return.
There is a valid point that if promoters of CDC schemes mis-sell them by overpromising the initial CDC benefit to attract members, then that will create political and legislative risk. It is important to ensure that CDC regulation is forward looking to prevent system gaming and self-interest from screwing up CDC schemes – which is why they should be operated on a profit for member basis and not a profit for the financial services industry/screw the member basis.
· I can't see many employers being interested in them at the moment.
There are at least five or six, which when one considers that there are probably no more than 20 eligible employers is rather impressive. As employees approach retirement age with inadequate DC retirement account balances, employers will find it increasingly difficult to retire employees without age discrimination claims.
CDC schemes for forward looking employers can help by enabling employees to afford to retire.
· I find current default and lifestyle arrangements too cautious. Investment strategy would become too remote from members, such individual members could not take ESG/climate change options more (or less) seriously.
This is a little confusing. It is possible that some members may find the investment strategy too remote, but these are most likely far fewer in number than those who find this an attractive feature. CDC schemes are not ideal for everyone; for some individual DC better suits their risk preferences and tolerances. But that group would lose the benefits of a collective arrangement. A responsive trustee board should be expected to reflect the ESG/climate change preferences to the extent that they can lawfully do so and also to report the consequences of following those preferences.
It is worth remembering that as at 31st December 2021, 96% of members in occupational trust based DC schemes with more than 11 members are in the default investment option: https://www.thepensionsregulator.gov.uk/en/document-library/research-and-analysis/dc-trust-scheme-return-data-2020-2021
· Intergenerational cross subsidies as demonstrated in Holland. The "advantages" of CDC all based on debatable assumptions not facts.
The Dutch system is very poorly designed. It is true that CDC is at this stage debateable, but the simulation techniques utilised which show advantages are tired and tested. And do not forget the Canadian risk sharing pension plans provide a real world example of more thoughtfully designed risk sharing arrangements: https://www.pensionspolicyinstitute.org.uk/media/2355/201410-bn69-rspp-the-canadian-experience.pdf . TIAA/CREF have been running a decumulation only CDC scheme in the US for over 60 years (it is badged as a variable annuity).
· It is neither one thing nor another, but has the potential of having the disadvantages of both.
This is a blinkered view – there can only be individual DC or employer sponsored DB in this view. To develop the disadvantages of both, would require both the scheme design and regulatory authorisation and supervision processes to have failed abjectly.
Since DB is for most private sector employees not on offer, the comparison is with individual DC which brings us back to the hardest problem in finance; how to manage an individual’s finances in retirement (including their own longevity risk) with individual DC when that is clouded by uncertainties and risks on all sides.
· It's a middle option that tries to meet all possibilities. Life is not that simple!
CDC does not lie on some line between DB and DC. In fact, a good case can be made that DB lies in a sense between individual DC and CDC but that this is not linear in nature. CDC does not try to meet all possibilities, it seeks to provide a practical and feasible solution to the income problem of retirement for members, given the realities of the world. Its aspirational nature indicates the limits of what is possible when thinking is only constrained to a world of only DB and DC.
· Lack of demand from employers and reputational damage/future litigation if in-retirement benefits ever needed to be reduced.
We have already covered the question of employer interest – the scope for reputational damage is extremely limited provided member communication is adequate. The prospect of successful litigation from scheme members is no greater than for individual DC schemes.
· Lack of overall control of its pension scheme by the employer, but this is becoming a choice for a variety of reasons.
Employers have a choice as to how they organise the remuneration package for their employees in consultation with (or agreement with) any recognised trade unions or employee representatives. If they are large enough to set up their own CDC scheme, with the legal and regulatory constraints they can determine benefit design. But if the rules for balancing the books and guiding the investment strategy are covered in the scheme’s trust deed, the trustee board not the employer is responsible for running the scheme. The lack of control in running the scheme is evidence of the independence of the scheme from any employer sponsors and serves to reduce the prospect of any liability resulting from the scheme falling upon a sponsor employer. Yes, the motivations of those currently investigating CDC arrangements are varied.
· Little obvious demand and conceptually/administratively difficult – certainly the membership will struggle and will the outcomes be what they need/ expect?
It is no more administratively difficult that DB – in fact, CDC schemes can be fully automated other than in the setting of new awards. It is difficult to see why a member should struggle when it is possible to report the performance of their contributions in near-real time, as well as the progress this represents relative to the aspirational targets originally made. The annual viability reports will inform them as to the level of benefits to be expected. As for what they need, the members will need to consider their state pension entitlement and their expected CDC pension to determine if that is adequate. With both progress and expectation being measured and reported there is little room for surprise disappointment.
· Managing member expectation.
· Members understanding the potential for their benefits to reduce.
These are communications issues.
· My DC post is my pot. I don't want to be subsidised by anyone else, and don't want to subside others either. I don't see why anyone else should either.
The starting point in the accumulation phase is what the remuneration package is. If it is CDC, that is what it is unless you can negotiate individual DC with your employer.
With CDC your pot is known as your beneficial interest in the scheme and the level of funding of that is reported to you. It is a mistake to consider risk-pooling and risk-sharing as subsidies of other members; they are arrangements for mutual benefit.
At the time of entering the decumulation phase, you can transfer to individual DC if that is what you want. You may enjoy the intellectual stimulation of grappling with the hardest problem in finance as to how to manage your finances in retirement (including your own longevity risk) when that is clouded by uncertainties and risks on all sides.
But the evidence of the number of trust based DC scheme members who are in the default investment option suggests that this is likely to be a minority interest.
· Need to go a way to be functioning and find a way to explain them to members.
This is true.
· No hesitancy just concern that fairness is designed in carefully and that those running the schemes and members understand that this is a best efforts structure as DB was originally. A small reduction in annual payouts from time to time is a small price to pay for the security of a pension to live on.
This is a balanced and considered comment.
· None. Seems an effective solution between the extremes of DB and DC.
We believe and hope so.
· Not fit for purpose.
I wonder what purpose this commentator had in mind.
· Prevalence of views from nay-sayers in the industry.
The naysayers do have a disproportionate presence in social media and other forums and have yet to present a detailed empirical model as to why CDC cannot work. This is a critical time in pensions and a robust evidence-based debate is necessary. Currently, all we have is unsubstantiated opinions from the naysayers. To this end, their motivations without evidence are something of a riddle wrapped inside a mystery, inside an enigma.
· Restricted individual investment choice meaning no option to try for higher returns. Does not accommodate all attitudes to risk.
It is true that all members will experience a common return, but it should be recognised that the returns achievable by a CDC scheme constitute a very high hurdle for an individual to overcome. Indeed, only an individual scheme could possibly accommodate the attitudes to risk of all. Those who wish to use individual DC are free to do so in the decumulation phase (and in the accumulation phase if .that is an option in the remuneration package). However, 96% of those in trust based DC schemes with more than 11 members are in the default investment option, so the restriction on investment choice is very much the minority interest.
· Small employer failures.
I simply do not understand why this is being raised at this time or that it may even be relevant when small employers are able to enrol employees in CDC schemes. Small employer insolvency has no greater or lesser impact in a CDC scheme than in individual DC.
· Sponsors originally offered DB pensions on a best endeavours basis which then became a burdensome guarantee and (usually) a large deficit on the company books. Sponsors will be wary of being caught in the same way again and will only offer CDC (via a MT or otherwise) if they are absolutely convinced that the commitment ends with paying agreed contributions.
This is a fair statement of an issue faced by the promoters of CDC. PSA 2021 should go far in alleviating these employer fears.
· The data has to be perfect all the time, or you will be paying out too much or too little to members taking their benefits.
Data quality is important, as it is in any form of pension provision. However, it does not need to be perfect all the time, there are considerable tolerances for error within a collective scheme, as well as the ability to put right earlier mistakes. Moreover, CDC should be built on new systems and infrastructure and not a variation on any legacy system, which will reduce the risk of low quality data that bedevils much of pensions currently.
· The dead hand of regulation.
We would fear more the active hand of misguided supervision.
· The delay in introducing a more open regime means we end up with just one CDC scheme for Royal Mail.
This is possible but unlikely.
· The fear of the unknown (to the UK).
Is this really a material factor?
· The market has moved to DC and is not going to go backwards, no matter how clever a CDC solution might appear to pension consultants.
This is an interesting view but unscientific in nature. CDC is not DB – we could ask the question: had CDC existed previously, would anyone have moved to individual DC? And the challenges of decumulation in individual DC and an adequate level of relatively stable income in retirement are going to increase pressure on employers to enable their employees to be able to afford to retire (because of age discrimination related claims).
· They are not something we have looked at so don't know enough about the risks, short and long term.
Not much to be said in response.
· Uncertain income.
This is a feature of CDC schemes but just how much variation we will see from the targeted pensions is an open question. Simulation studies indicate it will be very small, uncertainty of outcome abounds.
· Understanding by members.
The communication issue again.
· Will they actually provide a better result for members and employers than a well-run DB or DC scheme? At present a change to CDC would require an enormous leap of faith.
They should provide far better results than DB with far fewer problems and costs for employers – the regulatory regime is not as onerous. As for DC, there are very few individuals who could manage their own assets and achieve the lifetime 30% - 70% advantage of CDC shown in various simulations.
· With-profits pensions through the back door? Lots of scope for advisers to charge hefty fees for a DC (CDC?) arrangement, reducing member returns.
CDC schemes lack the commercial incentives that dominated the promises of with-profits and they do not practice the dark actuarial arts of bonus setting – simply put they are not with profits. The scope for high fees within CDC schemes is extremely limited by PSA 2021 and the regulations.