By Darren Baillie, Head of Digital Strategy (DC Pensions) at Hymans Robertson
The effect on individuals can be life changing. Much like handling dynamite, CDC can be a powerful source of retirement income adequacy and security, but ill-considered scheme designs have the potential to blow up in your hands!
Multi-employer schemes bring CDC within practical reach of typical companies through the scale benefits of investment purchasing power and lower administration costs. This means employers with potentially very different membership characteristics, contribution structures and life expectancies must coexist within the same scheme section. This is essential, but brings the potential for deliberate and inadvertent cross-subsidies between employers and groups of members. Rightly, there is less tolerance for these cross subsidies compared to those in a single employer scheme. The draft legislation acknowledges this challenge and sets a surprisingly high bar for demonstrating fairness in scheme design, compared to the single employer rules. It seems clear that the DWP’s overarching message is, ‘handle with care’!
Actuarial equivalence and scheme design
To maintain a sense of fairness, the draft rules require prospective schemes to satisfy a number of tests:
1. Benefits must be expected to rise with inflation, so members maintain purchasing power over time (before and after retirement).
2. There shouldn’t be cross-subsidies between employers.
3. There should either be no cross-subsidy between members, or if there is, each members’ benefits must at least match the value of their contributions.
So lots of work for actuaries and others in designing the benefits and operating the schemes. Although we expect there will be far, far fewer CDC schemes than DB schemes, the cost of all this work will be spread over far more people, keeping the costs proportionate.
The principle of actuarial equivalence is intended to eliminate cross subsidies between employers. But what might those cross subsidies look like and how can they be prevented?
Life expectancy – a key challenge
How long people can expect to live depends on factors such as sex, health, lifestyle, and affluence. One size doesn’t fit all. For example, a female bank manager from Surrey can, on average, expect to live a lot longer than a male manual worker from Glasgow. Analysis from leading longevity data analysts, Club Vita indicates that the difference in life expectancy for today’s retirees can be as much as 10 years. Typical life expectancies across employers are different, which won’t surprise anyone. The use of a single longevity assumption will mean that, on average, the lifespans of wealthy members are underestimated and the lifespans of the less well-off are overestimated. So, the contributions of the poorest would, in effect, subsidise the pensions of the wealthiest.
As a result, individuals who live longer could expect to receive 20% to 30% more value per pound of contribution than those with shorter life expectancies. While this is familiar to the DB world, it has largely disappeared in the DC world due to drawdown and annuity options tailored to individual member characteristics. Longevity analysis needs to be a key component in any multi-employer CDC scheme to avoid unintentional cross subsidies. It must be sophisticated enough to provide a realistic assessment of members’ life expectancies, and efficient enough to apply at scale and low/zero effort for members.
Benefit accrual
A simple single employer CDC scheme design would let all members earn benefits at the same rate for the same level of contributions through their working life. This is (relatively) easy to communicate and straightforward to implement. It does mean the contributions of the young effectively subsidise the pensions of older members. This is because the pensions of older employees will come into payment sooner so have less time to earn investment returns.
The scale of this difference might raise some eyebrows. Someone in their mid-60s might receive 10 times the value for each pound of contribution than someone in their early 20s gets in a scheme with this design. However, the expectation is that the young person will benefit from the other side of the cross subsidy when they’re older. This does require a stability of employment and employee demographic that is more likely to occur in a much larger employer.
The draft consultation for unconnected multi-employer schemes doesn’t allow these scheme design choices. In fact, it’s difficult to envisage a workable solution for a multi-employer scheme that doesn’t involve the pension a member earns being based on their age and the prevailing market conditions from time to time. This means the multi-employer solutions will have much lower cross subsidies than are allowed in the single-employer regime. But in doing so, it gives the industry a sizeable communication challenge to make all this transparent enough to manage members’ expectations.
Tackling the communication and design challenge
The complexity and hard work involved in solving these benefit design issues, implementing them, and most importantly taking scheme members on the journey shouldn’t be underestimated. The principle of accruing benefits in line with the market value of contributions is exactly what underpins conventional DC. Some participants might ask whether there is a more pragmatic way of realising some of the benefits of CDC without embarking on an onerous whole of life scheme design.
The DWP is yet to consult on decumulation only CDC and we hope that, as part of that, they will tackle the really important issues of default retirement and longevity pooling. This would open up more creative options for adequate and sustainable retirement incomes. Something as an industry we should all aspire toward delivering for members.
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