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Collective DC: the least worst option?

    Pensions and politics rarely mix, pension changes usually producing more losers than winners.  That said, the recent Budget’s liberalisation in respect of annuitisation may prove to be an exception. Politically shrewd, no doubt, but we are unlikely to ever know for sure whether it really was in retirees’ best interests. Annuities, after all, are pensions: it is very unclear what will replace them.

    Meanwhile, warming to the pensions theme, the Government’s attention has now moved to the question of how to maximise the size of a pension pot prior to retirement. Collective defined contribution pensions (“collective DC” or CDC) are now on the agenda. Their raison d'être is that CDC schemes spread risk (including longevity) collectively across members and across generations, thereby smoothing out temporary market anomalies. In addition, risk pooling facilitates scaling up, which helps to reduce per capita costs: it is cheaper to hedge risk collectively than as an individual. Sounds familiar? Underlying a collective DC pension scheme is a with-profits fund: this is a rebranding exercise par excellence.

    To be clear, there is nothing intrinsically wrong with the with-profits approach. The scandal of the 1990’s (Equitable Life et al) was prompted by people: life company executives harnessed complexity and opacity to manipulate surrender pay-outs. By depressing these below “fair value”, funds were able to boost their well-publicised maturity values (and bonuses) to attract more business. The latter’s cash inflow was then used to meet pay-outs so, when the ruse finally surfaced, it became clear that there were insufficient assets to support the liabilities: the pyramid then collapsed. Bernie Madoff pursued a similar business strategy.

    The DWP’s interest in collective DC is not new. In late-2009 it published a research paper which concluded that “the Government should take no further action on CDC schemes”. The DWP’s lack of enthusiasm stemmed from very legitimate concerns over inter-generational risk transfer, the same issue that sank with-profits: robbing worker Peter to pay out pensioner Paul.

    So what has changed? Actually, nothing, bar a few with-profits lessons learnt. But, notwithstanding the downsides of CDC, neither the DWP, nor the private sector, has come up with anything better. Collective DC could be the least worse option for future pension provision.  There is some evidence, notably from the Netherlands, where industry-wide CDC schemes have long existed, to suggest that CDC schemes’ socialisation of risk (i.e. going Dutch) does provide better average outcomes than standard DC schemes. But this is to be expected, because of cost reduction achieved through harvesting economies of scale. 

    Crucially, CDC schemes must be accompanied by prescriptive and transparent cost control levers, to be pulled with any hint of financial unsustainability. These can include conditional indexation (such as linking benefit accruals to the fund’s well-being), raising contributions, or even reducing pensions in payment. But this comes at the price of complexity, making communication with members that much more challenging.  In addition, it is hard to dispel concerns over whether even sophisticated risk management could really ensure generational equality. And CDC schemes would appear to rely on the fundamental assumption that they will operate in perpetuity, with a regular supply of new members. Risky.

    Critics of CDC point to “problems” with the Dutch experience, citing examples of schemes cutting back benefits by as much as 20% over recent years, with employers also having to increase their contributions.  But this could be interpreted as evidence that the cost control levers are working.  The real issue is whether CDC can cross the cultural chasm in working practices: the Dutch are more collaborative, and when scheme changes are required, they generally result from negotiation through works councils or unions. In addition, the Dutch are not burdened with the UK’s legislative constraints with regard to retrospectively amending benefits.

    The Dutch have accepted that pensioners should also share the burden. In 2012-13 alone, 66 Dutch funds cut benefits to restore funding ratios, affecting more than one million pensioners. It is unclear whether we British are prepared to cross the generational Rubicon. But until we do, we risk perpetrating inter-generational injustice, the key risk highlighted by the DWP.

    The government’s own track record of pensions cost control is farcical. Its reforms of public service pensions includes a cost cap that is supposed to share risk between employers (i.e. taxpayers) and public service workers. But the cap only applies in respect of future service costs.  It ignores the costs attributable to today’s pensioners and deferred members, 63% of the total membership of the Local Government Pension Scheme (LGPS), for example. In addition, the cap excludes the additional costs stemming from the reform exemption given to all workers within ten years of retirement. 

    Furthermore, if the cap were breached, “the government will consult on how to reduce costs, with an automatic default to be applied if agreement cannot be reached”. Nowhere in any public documentation is the consultation process, or the default mechanism, specified. One lesson from the Dutch is the need for specificity: instead, we have ambiguity and fudge, which is unlikely to produce union agreement, should the need arise. On this evidence, hopefully those overseeing collective DC scheme governance will ignore the Government’s own template for cost control.

    In the meantime collective DC is a potential source of political capital for the Government (albeit that the Conservatives will probably grab more than their fair share from the Liberal Democrats).  Advocating the collectivisation of risk provides a great opportunity to encroach on what is natural Labour territory. So maybe politics and pensions do mix, after all.

    Michael trained with JP Morgan in New York and, after 21 years in investment banking, joined Towers Watson, the actuarial consultants. Subsequently he was responsible for the running of David Cameron’s Economic Competitiveness Policy Group.

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