The Government has this week unveiled proposals to encourage Dutch-style collective defined contribution schemes in the UK amid concerns about the fairness of the structure and how it will mesh with radical liberalisations announced during the Budget.
Fresh from announcing the biggest shake-up to pensions in 90 years, the Government has revealed plans to allow employers to set up schemes where risks are shared collectively among members. While advocates claim CDC schemes can deliver the holy grail of reduced investment volatility and higher returns, the experience in the Netherlands – where CDC has been at the centre of a trade union storm – suggests the reality is far from straightforward.
CDC schemes function in a similar way to traditional with-profits schemes, using extra investment returns in the good times to make up for lower returns in the bad. Pensions are then paid out of a collective fund.
Frank Husken, managing partner at Netherlands-based firm AF Advisors, recently wrote a report for the Dutch government on CDC schemes. He says for them to be a success, the way peaks and troughs in returns are smoothed out – what he calls the “solidarity mechanism” – must be made clear from the start.
He says failure to do this in Holland has led young people to protest about subsidising the pensions of people who have already retired.
“Young people in universities are coming up with the research and the youth wings of political parties are using it to criticise CDCs,” Husken says.
“They are right. The measures taken to reduce payouts are too little too late, what is needed is for the solidarity mechanism to be set out in detail, in advance.”
Syndaxi Chartered Financial Planners’ Robert Reid says this intergenerational unfairness could be a risk in the UK too.
He says: “There is a big liability there and the risk is you pay decent pensions to one generation and the next generation gets shafted. But they have to keep shovelling in the money or the whole thing falls apart.”
It is not the first time the Government has been warned about this unfairness. In 2013, Lord Hutton said: “CDC schemes do not reduce risks but transfer them among generations. Some cohorts enjoy reduced exposure because others experience more.”
Aviva head of policy John Lawson adds: “The burden is usually placed on people still in work. Pensioners in the Netherlands are not happy with their cuts in payments but those not yet at retirement have got it even worse. They are cross-subsidising those retiring.”
In his Budget speech earlier this year, Chancellor George Osborne set out reforms to allow people access to their entire pension pot from age 55.
Lawson says the Treasury’s focus on handing greater freedom to individuals runs counter to the DWP’s bids to encourage collective pension provision.
“The Treasury and the DWP seem to be coming at this from completely different places,” he says. “Auto-enrolment and small pot transfers are both paternalistic decisions but the Treasury is saying everyone should be in control of their own choices. It would be helpful to know how these two things square.”
First Actuarial director Henry Tapper, an advocate of CDC, says: “Some say CDCs and pensions freedom are a contradiction, but it is only paper thin. The entire accumulation of workplace pensions is collective so we are already in collective land.”
Because pensions are paid out of a collective fund, CDC schemes rely on members not leaving early. Lawson says market value reductions, similar to those levied on some with-profits funds, could be applied to CDC schemes to discourage people exiting the fund.
He says: “MVRs would get rid of the risk to the fund [of people cashing in their fund at age 55] but the whole concept is completely incompatible [with the Budget reforms].”
Independent pensions consultant John Ralfe says although you could add on exit charges to stop people leaving, they would make joining the scheme less attractive.
He says: “The good news is you can get your money out, the bad news is it will be lower than you thought, then all you get is a Ponzi scheme because people are taking the money out. My with-profits was 20 per cent lower when the MVR was taken into an account.”
Advice firm Combined Financial Strategy director Jonathan McColgan says: “People do not like these sorts of charges or anything that looks opaque. It binds them to a product event though they don’t know how it will perform in the
future. It leaves them at the mercy of the actuaries.”
Advocates of the CDC model claim that because they are handled collectively they lead to lower fees and potentially better pensions.
In November, a report by the Royal Society of Arts claimed that, over the last 57 years, a Dutch CDC saver would have got a 33 per cent bigger pension than a UK saver in an individual DC scheme.
Speaking to Money Marketing earlier this year, pensions minister Steve Webb said that increase would not apply in every case but there is a “set of pretty plausible circumstan-ces” where that would be the case.
“It would be odd to preclude a scheme or model which if applied in the past would produce better outcomes,” he added.
The ABI has criticised the schemes for being unfair, opaque and regressive because low earners tend to have lower life expectancies than higher earners.
Tapper accuses the ABI of “scaremongering”. He says: “Insurance firms have every reason to have it in for CDCs. They have very little skin in that game because the margins are tight – the money is going to members and not being stuck in the financial services firms. Do we want rich insurance salesmen or rich pensioners?”
Whatever the realities of payouts, Confederation of British Industry’s head of public service reform Jim Bligh says employers will be reluctant to have to make decisions about pension benefits.
He says: “I’m not sure that is something an employer would like to do or something that employees would be keen on.”
Here to stay
Whatever the concerns over the specifics of CDC schemes, political consensus around the issue means what Webb has called a “defined ambition” looks certain to be a part of the UK’s pension future. Just over a week before the Queen’s speech, Labour’s shadow work and pensions secretary Rachel Reeves agreed there was a “compelling case” for CDCs.
She said: “It offers one way of achieving what is sometimes termed a defined ambition pension that some see as offering a middle way between defined benefit and defined contribution schemes.”
Lansons director Ralph Jackson says: “Webb has been looking at this for a while, enough people have told him about these schemes. Consensus is breaking out for the right reasons but whether it will work for the UK is the critical issue.”
Despite this consensus, these reforms will be judged on the extent to which employers buy in to the pensions minister’s risk-sharing vision. If they don’t, Webb’s “defined ambition” will remain unrealised.
The View from the Netherlands
Over the last few years there has been a transition from defined benefit to collective defined contributions going on in the Netherlands. The name collective DC suggests it is the best of both the DB and DC worlds. To a certain extent this is true.
There is still a level of solidarity between generations.
This enables the members of the schemes to pool investment risks and longevity risk over generations and to have an efficient execution of investment policy.
Also, in CDC one does not have to buy an annuity at retirement (which is the case in DC in the Netherlands), which allows for an investment in well performing asset classes after retirement.
But, the transition comes with some drawbacks too.
First of all there is a lack of transparency. In DB an individual knows what pension he can expect, in DC they know the value of the assets they are entitled to.
In CDC neither of the two is the case. The pension a member will receive is directly related to how the investment proceeds are distributed over generations.
Secondly, the financial crisis taught us that the distribution over generations is a difficult exercise.
The investments suffered, which led to a debate in the Netherlands about how much loss on investments can be absorbed by intergenerational risk sharing and how much of the loss should be absorbed by the current pensioners through lower pensions.
This debate became political and in some cases the appropriate measures were not taken.
In my opinion, the only way CDC and the corresponding intergenerational solidarity could work is by defining in advance how intergenerational solidarity works in practice.
Frank Husken is manageing partner at AF Advisors
Head to head
Are CDC pensions, with “risk sharing” in a collective fund, a better mousetrap for the UK than individual DC pensions? At the practical level CDC fans have failed to produce a detailed two-pager, for potential savers, showing exactly how it works. As described, CDC looks suspiciously like with-profits – discredited for lack of transparency – especially in the brave new world where pension savers take their cash rather than buying an annuity. At the theoretical level, the idea that CDC can produce a pension 30 to 50 per cent higher than the equivalent DC pension is misguided.
Fans say a CDC plan can take more investment risk – a higher proportion of equities – giving higher investment returns and a bigger pension, because it has a longer time horizon than any single individual. This is the familiar argument that investment risk reduces with time, so long-term pension savers should hold more equities.
But the proper measure of long-term equity risk is not the volatility of equity returns; it is the cost of buying insurance against underperformance versus the risk-free return – a put option on a stockmarket index. If risk really does reduce over time, the cost of equity put options should fall the longer the option period.
In reality, the cost increases the longer the option period, reflecting increasing not decreasing risk. The theoretical price and actual prices charged by banks are about 25 per cent for 10 years and 30 per cent for 20 years.
CDC can certainly transfer investment risk from one member to another or one generation to another but is not a magic wand to make risk disappear.
John Ralfe is an independent pensions consultant
CDC schemes will offer a new option to those approaching retirement. They may be offered “standalone” or as continuation options for master trusts and GPPs.
They will compete with individual drawdown and annuities. They will use institutional funds and governance, leveraging their size to get high-quality investment management at super-low cost.
We expect them to bring draw-down to the mass market, helping people spend their workplace savings through their later years while remaining invested in real assets. They are likely to become the investment vehicle of choice for those not looking to “cash out” or use bespoke drawdown. Such schemes depend on collective governance rather than individual advice.
There are several models for CDC ranging from a “with-profits” approach to more transparent unit-linked investments using differing types of dynamic asset allocation — we expect CDC to allow members to vary their drawdown of income depending on their needs, tax position and appetite for capital preservation. Having joined a CDC scheme, we expect people to have the option at any time to opt-in to an annuity or “cash-out”.
Depending on the level of ambition of the CDC manager, the scheme may also offer to pool risk across a generation of savers. More ambitious CDC schemes may allow the scheme to operate on a “whole of life” basis where there may be inter-generational cross subsidies.
GAD rates back research that suggests that by giving up the guarantees of annuities, people are likely to get around 30 per cent more income from a CDC pension. This is currently the case for those using such schemes on the continent.
Henry Tapper is director of First Actuarial