Defined benefit pensions, where an employer guarantees a pension for life, are almost extinct in the private sector. Defined contribution schemes, where people draw a pension from their individual pot and take their own investment and longevity risk, are now standard.
Some people claim “collective defined contribution” (CDC) pensions are a middle way between defined benefit (DB) and individual defined contribution (DC) schemes. CDC sets an annual “target pension”, based on member and employer contributions. Target pensions, including pensions in payment, move up or down each year, in line with the value of assets.
Guy Opperman, pensions minister, is certainly a fan, saying recently that CDC could “transform the UK pensions landscape and deliver better retirement outcomes for millions of pension savers”. The government has also just published a consultation on how multiemployer CDC could work. Is Opperman right?
So far, only Royal Mail has said it will start CDC for its 140,000 staff — part of a deal agreed in 2018 to see off threatened strikes — and it has lobbied hard for new legislation.
Royal Mail’s CDC scheme will have employer and employee contributions of 15.2 per cent of salary, which it says produces a target pension of 1/80th of salary, from age 67, with annual increases of inflation plus 1 per cent.
Over 40 years a member could expect a target pension of half average salary, 50 per cent higher than an individual DC saver could expect, for the same contributions and investment returns. It looks like collective DC is a clear winner. What’s not to like?
But Royal Mail’s CDC forecast is much higher than individual DC because its asset allocation is much riskier — an astonishing 100 per cent equities — than a typical individual DC.
“Higher risk equals higher expected return” is true, but is not very helpful in thinking about better retirement outcomes.
Fans say CDC captures expected long-term equity returns, with lower risk than individual DC, thanks to “intergenerational risk-sharing”, but explanations of how this works are notoriously vague.
Take an individual DC saver with a £100,000 pot, 100 per cent in equities. If the value of the pot falls by 20 per cent, then the forecast pension, including inflation increases, also falls by 20 per cent.
What about a CDC scheme with 10,000 members and £500mn of assets, 100 per cent equities? If assets fall by 20 per cent, then forecast pensions, including inflation increases, fall by 20 per cent — just like individual DC.
Although the 10,000 members have different retirement dates, this does not smooth outcomes. If assets fall by 20 per cent in a year then the value of the target pension, including annual increases, for a 90-year-old, 80-year-old or 70-year-old pensioner, all fall by 20 per cent.
The value of the target pension, including annual increases, for the 60-, 50- or 40-year-old not yet retired, also goes down 20 per cent, even though they will retire on different dates.
Expected returns and risk are identical whether equities are held in an individual or collective DC. And the actual annual return, whatever it is, means the same change to forecast individual DC or collective DC pensions. For any identical level of contributions and investment risk, collective and individual DC outcomes are identical.
If an individual DC saver wants a higher expected return, they can simply hold more equities. If they are happy with the risk of 100 per cent equities, their forecast pension will be identical to Royal Mail CDC.
Individual DC has the killer advantage that each saver can choose their own asset allocation, to suit their personal risk preferences, which probably changes as they get older. But CDC asset allocation is identical for all members, regardless of age or risk preference, so will be “suboptimal” for virtually all of them. Some will prefer more investment risk, some less.
Communicating pension information is crucial in getting people to make better decisions about how much to save, when they can afford to stop working, and how much they will get in retirement.
By definition, both individual and collective DC pensions are DC, so member communications should include exactly the same information.
Annual individual DC statements are required to show the opening value, contributions, and closing value. Collective DC statements should be the same: the opening cash transfer value — how much the member can withdraw to move to another pension — contributions, and closing cash transfer value. How the value of DC assets has changed — individual and collective — must be crystal clear.
Individual DC statements also forecast the size of annuity, or guaranteed pension, which could be bought at retirement, and collective DC statements should show this too.
Individual DC statements are not required to forecast the inflation-adjusted pension if a saver chooses not to buy an annuity but moves into drawdown. This should be required for both individual and collective DC.
This may all seem uncontroversial, but the CDC communication requirements, set out by the government and pensions regulator, are weak, and will create a smokescreen.
DC pensions — whether individual or collective — can only be paid from contributions and investment returns. If contributions and asset allocation are identical, then “retirement outcomes” for individual and collective DC must also be identical.
Unfortunately, focusing on shiny new CDC schemes diverts public policy energy from the less glamorous job of improving how individual DC pensions work.
John Ralfe is an independent pension consultant. Twitter: @johnralfe1