By Danny Wilding FIA, Partner at Barnett Waddingham
The key differences from classic individual DC in the UK are the pooling of investment and mortality risks between members, and the central management of the collective fund.
How could CDC decumulation fit into the UK pensions context
A lot of focus on CDC in the UK has been around the development of the Royal Mail scheme – a single employer, whole of life, target-benefit scheme. While this has been a great trailblazer for CDC in the UK, even if other similar schemes are launched the benefits of pooling pension risks through CDC will only be felt by a minority of the current workforce (i.e. those spending most of their working life in such a CDC scheme).
It feels imperative that the principles of pooling risk to achieve better overall retirement outcomes should be applied in a way that will benefit the largest number of individuals. The majority of active pension savings in the UK are now in DC arrangements and the proportion is likely to carry on growing for the foreseeable future.
While a long-term aspiration may be for multi-employer whole of life CDC schemes to be widely used, there is no guarantee of this becoming a reality and it will be decades before the first individuals retire on largely CDC benefits. Developing CDC decumulation solutions that all current DC savers can access at retirement would bring the benefits of CDC to more people and much sooner, bridging the gap for the current generation of savers between the past era of DB guarantees and the potential future of CDC.
A major risk of launching multi-employer schemes is not achieving the required scale to run efficiently – it may be hard to bring together different employers with different needs to build the pool to sufficient size. The success could well be very dependent on investment returns (and benefit increases awarded) in the early years, as this will influence confidence in the scheme and poor early experience could lead to difficulties attracting more employers.
Further, the promotion of whole of life collective schemes is in conflict with the culture of individualism fostered by UK pensions policy since the launch of “Freedom and Choice” in 2014. Focusing instead on decumulation solutions would fit more naturally with the idea of individual choice at retirement that we have at the moment.
Meeting needs of individuals
Despite the shift in occupational pension provision from DB to DC over the last few decades, we still typically think of a pension as an income for life. This represents a challenge when converting a DC savings pot into an appropriate retirement income and currently the responsibility for resolving this lies solely with individuals.
One much debated risk is DC drawdown fund exhaustion. We expect the government will be concerned with this as those running out of funds will end up falling back on state benefits and in some cases this could be avoided with better financial planning.
On the other hand, our research on the Australian DC market, which is more mature than here in the UK, suggests there is also the risk of an excessive focus on capital preservation in DC drawdown in an established market, which leads to people not drawing enough from their pension pots for an adequate retirement income.
In the UK, we have not yet had to tackle DC decumulation having to fund the whole retirement of many individuals, as the current generation of retirees typically still have a reasonable proportion of DB benefits. However, in planning ahead for future generations we expect that giving support to individuals at retirement will be crucial. Individuals will need to consider their basic spending needs and aspirational spending separately to assess how to use their DC retirement savings appropriately.
Given the spirit of individualism since the introduction of Freedom of Choice, it is unlikely that many individuals retiring in future will want to put 100% of their retirement savings into a collective scheme (in the same way that individual insured annuities are rarely the only option chosen). However it may well make sense to use a portion of DC pots to provide an income for life through a decumulation CDC scheme to meet at least basic spending needs (in theory at more attractive rates than annuities) and use the remainder to fund discretionary spending through a drawdown arrangement.
How might the future look for CDC
Our view is that there is room for CDC decumulation arrangements within the current UK pensions system, which could sit alongside the current DC options of retirement cash, income drawdown and lifetime annuity. Individuals using this new option would gain some benefit from the pooling of mortality and investment risks in retirement, in a way that is not possible in the UK DC market at the moment.
There is a range of possible structures for such arrangements, so UK policymakers should learn lessons from those that can already be observed in other countries. The Netherlands will soon provide two examples of slightly different CDC arrangements in action, as after over ten years of pensions based on full pooling of investment and mortality risk, the Dutch system is now undergoing a massive overhaul.
The reform will see focus shift to individual pots (similar to classic DC) with elements of collective investment management, with the post-retirement decumulation phase retaining these individual pots but with investment and/or mortality risk pooling options. This is intended to tackle issues present in the current Dutch arrangement, which the UK would have to contend with should it more widely adopt CDC – namely cross-subsidies between very different membership groups (e. g. young active members and retired pensioners) and communication of benefit aspirations changing over time.
Whatever system the UK decides to adopt, such arrangements should not need to rely on individual employers to set them up, or to sign up to a multi-employer CDC scheme – they should be accessible to individuals making choices at retirement and therefore would more naturally sit within DC Master Trusts or insurance companies (if legislation permits).
With the time horizon until we have many retirements funded entirely by DC benefits growing closer, we feel that government policymakers and the pensions industry should be working together to move forward with pooled pension solutions in retirement for the current working generation – while the UK pensions mindset is still centred around an income for life. Otherwise we run the risk that over time the move to DC savings changes the culture towards the “pot of money” preservation attitude seen in Australia, and the associated issues seen there.
Innovation is needed urgently to guide people at and during retirement, with regulation to support this, and CDC decumulation has the potential to play a major role in this area.
Senior Consulting Actuary Robbie Tink was a key contributor to this article.
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