By Paul Waters, Head of DC Markets and Phil Hardingham, Risk & Modelling Consultant at Hymans Robertson
If the UK increasingly considers CDC, can we learn anything by looking further afield? Which risks and benefits are good to share, and which aren’t?
Dutch experience
The Dutch Pension Act, which came into force from 1 July 2023, marks a shift away from DB and CDC arrangements toward DC pension provision in the Netherlands. Notably, this is the opposite direction of travel compared to those currently being suggested by the UK government.
What has catalysed this shift in the Netherlands? Why are they reforming, when Dutch pension provision is rated as among the best in the world?* In short, members didn’t understand the risk sharing mechanisms behind the system, and this led to cries of intergenerational unfairness when difficult decisions around pension cuts arose.
Only a fool learns from his own mistakes, a wise man learns from the mistakes of others
Otto van Bismark - German statesman and diplomat
What can we learn to avoid the same about-turn and keep the introduction of CDC on a path to success?
It will be important for those working on pension scheme design to decide which risks and benefits get shared, and which don’t.
They’ll typically consider the implications of design decisions on members and it will be vital to ensure that the design leads to better outcomes.
But… this isn’t quite the same question a member’s asking. A member is less concerned about “what does this mean for all members?” and more focused on “what does this mean for me?”. And, at its heart, this is a question of fairness and transparency. Members must be happy with the pension they’ll get out, given the contributions they’ve paid in.
Importantly, fairness in isolation isn’t sufficient. It won’t wash if some members think they’re getting a hard deal and they don’t understand why, even if their lot is actuarially fair according to scheme rules. Instead, for a CDC system to be successful, members need to view the risk sharing mechanisms as transparent and equitable.
What should the pension industry do?
1. Split the pension scheme
Ensuring pension entitlement can be easily attributed between individual members is likely a minimum for this transparency. This needs to be explainable, too. Those designing pension systems must articulate simple, clear, responses to members’ questions. “What’s my pension entitlement? How’s it evolved from last year? Why?”
2. Be pragmatic about pooling
Pooling different sources of risk (investment, liquidity, longevity) is the core mechanism to improve members’ typical outcomes. However, there’s a balance to be struck between efficiency, and transparency. There will likely be cases where pooling risks across the membership may make sense ‘mathematically’, but not be worth it practically given the additional complexity and opacity it introduces.
3. Focus on the difficult scenarios
The challenges around intergenerational unfairness will invariably arise when there are painful outcomes to allocate. How can this possibility be communicated clearly, both before and after such a scenario? Can these explanations be tested with real-world members, to ensure they are straightforward and clear? There are a lot of exciting possibilities around alternative pension design, which may drive better outcomes in terms of security, flexibility, and income levels. However, as momentum behind longevity pooling and CDC grows, as an industry we need to avoid getting caught in a proverbial echo chamber and ensure that any design is pragmatic and simple enough to retain the confidence of the members themselves, those who we believe would actually benefit from it.
It's a rare opportunity when you get a blank sheet of paper to design from in the world of pensions. The decisions made today could affect millions of people for decades to come. As an industry we have to get this right, and lessons from abroad can teach us a lot.
*Mercer CFA Institute Global Pension Index 2022
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