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Playing with the pension system is a national political sport in the UK, but the coalition government has recently taken it to extremes.
On the one hand, it has granted pension savers freedom to cash out of the system after retirement, rather than having to use their savings to provide an income. On the other, it is legislating for the introduction of new collective schemes that will only work if people stay put in them after retirement.
Confusion reigns, and commentators are not optimistic that the proposed collective defined contribution schemes will ever get off the ground. Do they deserve to?
The main claim in their favour is that they will deliver a higher and more predictable retirement income than the standard defined contribution schemes that employees in the UK are being automatically enrolled into.
The modelling behind this finding rests on the assumption that CDC schemes can invest more and for longer in riskier and less liquid assets (such as infrastructure) than DC plans. This is because the risks are shared between scheme members rather than borne individually, and pensions are paid from the plan.
In addition, investment returns are smoothed so there is some protection against market fluctuations, and targeted benefits could be salary related and inflation protected.
They would be targets rather than guarantees, though, subject to adjustment if investment returns are too low to meet them, including potentially to pensions in payment.
Still, as a halfway house between defined benefit pensions, where the sponsoring employer takes the investment and longevity risks, and DC, where the risks all fall on the individual, the CDC proposal has attractions.
The difficulty lies in believing the risks can be well managed and fairly shared between scheme members. Where is the evidence to support such a view?
CDC supporters point to the Netherlands, which is often held up as an example of a top notch pensions system. The Dutch began switching to CDC-style schemes around 10 years ago, although the UK government’s consultation on so-called Defined Ambition pensions (of which CDC is a subset) suggests Dutch pensions have long been of this type, but were presented to employees as defined benefit. There was always flexibility to adjust benefits, but little need to do so before the financial crisis hit.
Since then, some schemes have had to increase contributions and forgo inflation-linked increases to pensions in payment.
This hardly constitutes a disaster and, according to OECD assessments, the Dutch still enjoy excellent pension benefits. They boast the lowest old age poverty rate in the OECD (1.4 per cent, compared with an OECD average of 12.8 per cent) and enjoy pension income equivalent to 91 per cent of previous earnings on average, against 54.4 per cent for the OECD. Their schemes are also low cost, with only Denmark ahead on this front.
The Dutch system cannot necessarily be replicated elsewhere, though. It is mandatory and most of the assets are run in not-for-profit pension funds, some of which have significant scale. It is also trusted, a key factor where risks are shared across generations. There is much less evidence in the UK to support the idea that CDC schemes can be made to work. In fact, it mostly points the other way.
The nearest equivalent is the with profits investment approach offered by life assurance companies that was popular in the 1980s and 90s. With profits funds were supposed to smooth returns, holding back money in good years to boost payouts in bad years.
They appeared to work well (for people who stayed put for the full policy term) until the late 1990s, when it became apparent that insurers had over-promised and under-reserved. Given this experience, perhaps it is no surprise that the Association of British Insurers is underwhelmed about the introduction of CDC schemes. It says the benefits are exaggerated and there are “issues about intergenerational subsidy and transparency which could prove challenging in today’s society”.
Will Aitken, senior consultant at Towers Watson, points to another problem. In the countries where the CDC approach has gained traction, defined benefit schemes have converted to CDC. In the UK that is not an option, so unless DC schemes made the conversion, CDC schemes would have to start from scratch, which would be costly.
Tom McPhail, head of pensions research at Hargreaves Lansdown, is likewise unable to see how CDC schemes could gain the scale they need. They are “a good idea at the wrong moment”, he says.
Still, if much of the pensions industry is wary of the idea, maybe CDC schemes do have merit – if they survive the government’s game of political football.
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