By Jon Hatchett, Senior Partner at Hymans Robertson
But to really understand the pros and cons of different CDC benefit designs, we have to examine the roles of the different forms of collectivisation.
Collective investment
Most DC schemes effectively do this to some extent. Members are invested in collective investment vehicles and in trust-based schemes, the scheme assets are held in the name of the trustee.
So, what is the promise of collective investment in CDC? Largely, it’s that trustees would feel enabled to invest in riskier assets for longer, seeking greater returns over the lifetime of members. This potential for greater risk taking is based on the premise that the older members, with lower tolerance for risk, pass that risk on to younger members of the scheme. So, to believe in collective investment, you have to believe that younger members can tolerate more volatility than they do in today’s DC schemes. An important question then, is whether we can go further in traditional DC? In our view, the answer is yes, and the growing sophistication of the largest schemes and master trusts are already doing much more, including:
Pushing the envelope on default retirement pathways – although help from the incoming government would make a world of difference.
Broadening the investment universe using, for example, illiquid strategies – with the investment sophistication and ability to manage flows within the member base being key.
If you believe in the greater tolerance for risks provided by younger members taking on more risk, you can seek higher returns (at higher overall scheme risk in your default investment strategy).
Those playing devils advocate might argue that you can get some of the greater risk taking through using leverage to increase risk exposures beyond 100% in traditional DC. Clearly the risk/reward trade off is different to CDC, but it becomes more comparable.
Collective longevity
This is a clear gap for existing DC. Collective longevity solutions are available through annuities, but while annuity sales have risen as gilt yields have gone up in recent years, they’re still a minority rather than majority solution. And the lack of flexibility is unacceptable to some.
This is where the economic inefficiency of traditional drawdown comes to the fore. An individual member doesn’t know if they might live for three years in retirement or 30. And so individuals self-insuring this risk through their own drawdown pot is not an effective way to manage a pension income.
Collective longevity, through longevity pools in drawdown, provides a clear way to get income uplifts and reduce risks. As with any option, it won’t suit everyone. For those who would prefer to spend their pension income while they are alive rather than pass it on when they die, it may materially boost retirement incomes. However, passing on an inheritance from their pension is a priority for others, and so this clearly wouldn’t be for them.
Collective funding
Alongside longevity, pooling funding is the other major innovation in CDC. It comes with important pros and cons which is why we feel understanding the benefits of the different elements of collectivisation is important.
The pros and cons are related to the cross subsidies you get with pooling funding.
As set out above, CDC schemes generally mean that younger people take more risk, upside and downside, than older people. If asset out/under performance feeds through to pension increases before and after retirement, the impact of financial market volatility on the notional fund for a 35 year old might be 10 times that for an 85 year old.
Depending on your scheme design, these cross subsidies can impact:
The benefits earned each year in a whole of life scheme – do the younger active members “top up” pots for older active members?
They may, but may not, reap the benefits of that when they are older themselves.
Do active members “top up” or get “top ups” from deferred and retired members as market conditions shift?
In a multi-employer scheme, do employees from some employers “top up” benefits for employees of other employers?
In decumulation only schemes, do new retirees “top up” benefits for existing retirees?
All of these are design options that can be worked around. Doing so in a way that is simple to communicate to members is not necessarily going to be easy though!
It seems reasonable that the average 20 year old or 40 year old would have a higher risk tolerance for their expected pension to go up or down, compared to the average 80 year old’s tolerance for changes in their actual pension. So shifting risk to younger members, on the expectation they will be old one day, feels like the “free lunch” in collective funding. And what’s not to like about a free lunch? Building intergenerational bonds through the scheme is a positive societal benefit.
However, the other forms of intergenerational cross subsidies are more complex and can either benefit schemes or become their Achilles' heel. Particularly over generational lifetimes, where we know from experience, market conditions or longevity outcomes will change in ways we cannot predict today. Can we take members on a journey where they understand the sorts of things that might happen and feel ok about that when things do happen? And do they understand what they are paying for?
With the upcoming election, the consultation on regulations for multi-employer CDC has been pushed back. So we have to wait and see what will come. It seems to us that we can do a lot with all three forms of collective benefits, but finding the right mix will take creativity, time and energy. We look forward to playing our part in the industry in making this happen.
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