By Kate Smith, Regulatory Strategy Manager at Aegon UK
2014 was already shaping up to be a pivotal year in pension reform, but with an election fast approaching, the Pensions Minister Steve Webb, is showing no sign of slowing down the pace of change. The Queen’s Speech contained a proposal to enable UK employers, from 2016, to set up new Collective Defined Contribution (CDC) schemes for their employees. The Private Pensions Bill will introduce a new pension legislative framework later this year. This will set out the definitions for three different categories of ‘pension promise’ schemes for individuals in the savings phase. A scheme will be either Defined Contribution (DC), Defined Benefit (DB) or, the new ‘middle way’, Defined Ambition (DA).
Under DC schemes, including personal pensions, individuals bear all the risks including investment, inflation and longevity, whereas under DB schemes the employer bears all the risks of a pension promise. The new legislation, for DA schemes and the new CDCs, will allow greater risk sharing between employees and employers, which should drive market innovation. Over time it’s possible that very different DA models could develop, but this depends to a large extent on employer demand.
CDCs are basically money purchase arrangements. Like traditional DC the employer and employees pay a fixed pension contribution. On retirement a targeted pension is provided, but the amount isn’t guaranteed. The actual amount paid from retirement date may be more or less than the targeted pension, and could, in the worst case scenario, actually fall while in payment. All payments depend on the funding position of the scheme, which is subject to a whole host of economic and market conditions. And much like a DB scheme this will depend on the CDC’s assets, liabilities, membership profile and size, as well as actuarial assumptions.
It’s argued that the combination of economies of scale and removing the need to buy an annuity could improve retirement incomes by more than 20% compared to traditional DC. It’s also argued that CDC has the potential to smooth out investment risks giving less volatile member outcomes. Scale is a good thing. It means lower investment charges, which in turn means higher returns. It also means lower administrative charges as fixed costs are spread more widely across a large membership.
In addition, and differently from traditional DC, the collective nature of CDCs also means that risk is pooled between members, and across the generations, and pensions are paid directly from the scheme. This avoids the need for individuals to de-risk from equities to gilts and cash in the run up to retirement to match annuities. Funds can be held in higher performing assets for longer, benefitting members right up to retirement age.
At first glance the CDC model offers a number of benefits, but the UK has a markedly different pensions culture to the Netherlands, and it’s important that we recognise these differences before any future CDC design is chosen. Unlike in the UK, employer led pension saving is mandatory in the Netherlands, where workforces are heavily unionised and trade unions play a leading role in pension provision. Furthermore, there is an acceptance of collectivism and intergenerational risk sharing, and collective bargaining is used to balance the interests of employees and pensioners. It is true that the collective nature of CDC smooths investment returns, with returns in good years compensating for those in bad, but in such circumstances, where the young effectively cross-subsidise the old, a steady flow of new entrants is essential. Put simply, the scheme profile and size has to be protected to ensure scheme longevity. Allowing employees to opt-out would dry up contributions, and allowing transfers out would reduce assets.
This culture is not endemic in the UK, where people want more individual choice and control. There’s a direct conflict here with the 2014 Budget which has promised individuals more flexibility about how they take their pension – whether as an income or lump sum once they reach age 55. Under the Dutch model there is no such flexibility. Members can only receive their pension at the time and in the format set out in the scheme rules, leaving them very little room for manoeuvre to fit with their circumstances and lifestyle ambitions.
The Private Pensions Bill starts going through the parliamentary process later this year with the hope of becoming a Pensions Act before the May 2015 election. This will be closely followed by regulations, and guidance, with potentially strict rules on the actuarial assumptions, allocation of returns along with member disclosure and reporting rules. The government needs to set out how DA models will fit in with existing regulations on auto-enrolment, auto-transfer of small pensions pots, and the new DC retirement flexibilities to name a few. Only then will we begin to gauge whether employers, and employees, are really interested in the new ‘middle way’ pensions.
|
