I’m no actuary, so I bow to Willis Towers Watson’s experience in mathematical modelling, based on the assumptions they made about relative returns of collective defined contribution, defined benefit and individual DC pensions.
The firm makes a good case for CDC. It’s hard to argue that a pooled investment fund unconstrained by benefit promises won’t produce better long-term returns. This ought to follow from the freedom to stay invested in growth assets for the long term and include high-yielding illiquid assets like infrastructure.
Moreover, it is equally credible that CDC would outperform a DB scheme, pound for pound. Benefit promises and funding rules tend to force schemes to invest disproportionately in low-yielding gilts, and this is compounded when the scheme is closed (as most are today).
But why have they been closed? Because they have become too expensive to run.
Two question marks
Tellingly, the modelling also assumes that DC savers would de-risk from age 57 and annuitise at 67, using current historically low annuity rates.
To me, there are two fundamental flaws in this assumption: firstly, annuitisation; and secondly, that ultra-low rates will persist indefinitely.
According to the Financial Conduct Authority, in the first half of 2019, annuity sales made up just under a fifth of all decumulation product sales, down from 30% in 2016 and 67% pre-2015. This suggests that individual annuities are no longer an appropriate comparator to use against CDC.
Meanwhile, we’re in a period of unprecedentedly low interest rates, with governments around the world borrowing at an unsustainable rate. Over the medium to longer term, defaults and ratings downgrades are likely to push bond yields northwards again and mean at least a partial recovery in annuity rates.
But for an up-to-date comparison of outcomes, I’d like to see this same analysis of CDC performed against taking an equivalent income from a drawdown portfolio. This would model whether the drawdown option chosen by most people today would be likely to last the full retirement timescale.
The second key assumption is that members would benefit from the same rate of contributions across all three scheme types. Yet WTW’s own survey of FTSE 100 companies (the sort of firm who used to run DB schemes) showed that the average employer contribution rate for their DC plans is around 8% for non-matching schemes and 11% for matching schemes.
Employer contributions to private sector DB schemes, by contrast, average out at over 19% according to the latest ONS data. This is important, because it shows that in practice, it is not the member but the employer who benefits from the transition to DC.
With my basic maths and assuming employers paid in contributions more typical of individual DC schemes, benefits from contribution-matched CDC schemes are likely to be 17% lower than from a DB scheme, or 48% lower for a non-matching scheme.
The real case for CDC
This is not to say that CDC is a bad idea. I am a huge fan of the collective pooling of risk, a concept that is being steadily eroded as insurers leverage more granular data to target the lowest risk customers and government policy drives us further towards individual responsibility. There is a great deal to commend CDC to result in better benefits than individual DC on a like-for-like contributions basis.
However, I fear that the horse has already bolted the stable. Had CDC been made available before most of the UK’s final salary schemes had been closed, this would have been an ideal opportunity to mitigate both escalating costs for employers and longevity risk for members. Now that individual DC has become the default, it is hard to see firms incurring increased cost to set up new trust-based CDC schemes.
As WTW’s Simon Eagle puts it: “For CDC to become prevalent in the UK we would need further regulation from the government enabling CDC master trusts.”
The master trust construct offers a sizable saving in scheme governance costs. This could present employers with a viable alternative to contract schemes and individual DC master trusts, and members with uplifted benefits per contribution pound compared with either of these.
However, employers would still need to invest in educating their workforces about how CDC works, and may encounter resistance to the possibility that these schemes can in some circumstances cut pensions in payment. Regulation might have to go further, in the form of compulsion, to create a big enough driver for real CDC take-up.