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John Ralfe: Why collective DC is a con trick

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Is the pensions minister right to claim that “collective defined contribution” pensions could deliver pensions 30 per cent higher than the equivalent individual DC pension?

CDC fans acknowledge this is only an average increase in pensions and that without an employer standing behind it, the guarantor can only be future generations of plan members.

A CDC plan would require strict and transparent solvency rules, with the ability to cut pensions in payment and even claw back pensions already paid if solvency deteriorated due to poor investment performance or increased longevity forecasts.

Without such strict solvency rules a CDC scheme would represent a transfer from younger current employees making contributions to older pensioner members and would become a Ponzi scheme.

A CDC plan could certainly have lower transaction costs, from economies of scale, auto-enrolment and passive-only investment options which, compounded over many years, would lead to a higher pension pot, but existing arrangements, especially the National Employment Savings Trust, can already do this.

But a higher CDC pension is not really about lower transaction costs – it is about the “risk sharing” that supposedly comes from contributions being paid into a collective fund, not into individual savings accounts.

Advocates say that because it has a longer time horizon than any single individual, a CDC plan can take more investment risk – a higher proportion of equities, a lower proportion of inflation-protected bonds – to generate higher investment returns and a bigger pension, with no need to buy an annuity.

This is the familiar argument that the risk that equities will earn less than inflation-protected bonds decreases 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 past equity returns; it is the cost of buying insurance against underperformance versus the risk-free return – a “put” option on a stock market 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 work only if third party investment banks or insurance companies are prepared to provide guarantees of long term equity outperformance. If holding equities for the long run does lead to higher average returns, with negligible risk, the cost to individuals of this guarantee should be modest reflecting the (supposedly) modest risk.

Unless this happens – which it won’t – CDC is a con, persuading individuals that the risk is less than it really is. Fund managers would do well out of CDC because they would be able to charge higher fees on equity funds. It would also provide work for underemployed future actuaries to value the plans.

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 pension consultant 

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Comments

There are 4 comments at the moment, we would love to hear your opinion too.

  1. Great observation by John – CDC is no free lunch, unless of course Mr Webb has a new option pricing theory to publish in the hope of becoming a Nobel prize winner ?

  2. CDC at retirement doesn’t have to involve a ‘rob Peter to pay Paul approach’. Pensioners could be offered income up to 30% more than would be achieved from an annuity and still have a reasonable expectation that the pension could be sustainable (a ‘best endeavours’ basis). However, the potential for that pension to fall in later life would need to be clearly explained and a robust approach taken to monitoring the pension that could be afforded on both a ‘best endeavours’ basis or from a guaranteed annuity. Members would at all times have the option to choose to buy a guaranteed pension or to continue taking pension on a ‘best endeavours’ basis. Offering this system on a large scale would give such options on better terms than are available on individual retail grounds.

    For this to work, there needs to be excellent governance & communication standards and for employers to be assured that pensions offered on a ‘best endeavours’ basis will not and cannot become liabilities that the company has to meet.

    Without the latter, I am not convinced there will be many employers willing to sponsor schemes that offer this option at retirement. And, of course, calling a pension scheme a ‘con trick’ in the FT and other places isn’t going to make any employer inclined to think about it. If John feels these schemes have no merit and should be stopped now then he should carry on calling them ‘con tricks’. If though, he can see some merit then I’d ask that more helpful language is used and that CDC supporters refrain from trying to bank a ‘free lunch’ that doesn’t exist.

  3. Ah John.
    You start from the premise of assuming that Webb knows his backside from his elbow.

    You could have saved yourself a lot of trouble (and a much shorter article) by using one sentence in addressing the buffoon who is the minister for pensions:.
    “Please shut up you idiot – you have proved beyond doubt you know nothing about pensions”.

  4. As usual the theory sounds fine but the practicalities will mean that as soon as Europe gets involved the costs will increase as rules to ‘protect’ members mean that just like final salary pension schemes the actual amount that can be invested in equities for growth falls meaning that new members subsidise retired members just like the state pension.

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