This article first appeared in CSFI’s Financial World magazine, 1 July 2014.
This year politicians have promoted pensions to top billing, with both the recent Budget and the subsequent Queen’s Speech containing pensions-related initiatives. But the response to them could hardly have been more different. The Budget’s liberalisation concerning annuitisation was widely welcomed (indeed, the media chatter exuded excitement, rare for pensions matters). The Queen’s Speech, however, flagging the prospect of collective defined contribution (collective DC, or CDC) pension schemes, was greeted with almost total indifference. So, why the different reactions? In a word, relevance.
The Budget’s removal of any requirement to buy an annuity (from April 2015) is a classic Conservative initiative that embraces personal freedom and liberty. This resonates with the individual, and the benefits are pretty immediate, notably a pot of cash at retirement, rather than a relatively small annuity until death. On money matters, people are inherently over-optimistic, so the risks (of not purchasing an annuity), which include running out of money before dying, are irrationally dismissed.
Conversely, collective DC schemes are workplace-focused: the individual is an anonymous member. CDC schemes’ raison d'être is that they 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. So, CDC schemes have some sensible attributes, but they only offer the individual the prospect of non-specific, time-remote benefits. In addition, these can only be measured against the counterfactual (i.e. unobserved events, or events which did not occur). And given CDC’s complexity (and an unfortunate with-profits echo), it provides a membership communications challenge. It is no surprise that Britain’s workforce is unmoved.
A bigger question is whether scheme-sponsoring employers will engage with CDC. Today, such schemes would fall into the regulatory no-man’s land that separates the two very distinct worlds of DC and DB (defined benefit). But before the Queen’s Speech, employers were not exactly clamouring for the new legislative and regulatory frameworks that would be required to facilitate CDC. And herein lies the rub. CDC’s announcement is the result of years of lobbying by consultants: there is little (if any) evidence to suggest it was demand-led. Corporate Britain has almost entirely exited DB provision, with its unsustainable costs, for DC: it is most unlikely to partly back-pedal into the uncertain middle ground. For aspiring CDC consultants, the Queen’s Speech is likely to prove to be a hollow victory.
Meanwhile, advocates of CDC continue to cite “up to 30% better outcomes” than saving in an individual DC scheme. They enthusiastically point to 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, primarily because of cost reductions achieved through harvesting economies of scale: individuals lack the bargaining power of corporate-sponsored schemes. But these could be garnered without embracing CDC, through scheme mergers (perhaps specific to particular industries), or by joining the likes of NEST, NOW Pensions or The People’s Pension.
The UK is littered with tens of thousands of sub-scale workplace schemes, delivering sub-optimal performance. One route to scale is strong governance, but professional trustees, for example, who should be driving mergers in the interest of members, are conflicted: fewer schemes means less business. In Australia there are fewer than 220 schemes, achieved by state strong-arming that, in effect, forces schemes to scale up. The UK should follow Australia’s lead, perhaps through having The Pensions Regulator (TPR) demand that workplace schemes demonstrate that their members are not being disadvantaged by a lack of scale. It could also provide guidance as to what it considers an appropriate level for minimum membership... 25,000, say.
As an additional cost cutting measure, TPR could also follow a recent Government initiative that is likely to require the Local Government Pension Scheme to move all of its £85 billion of actively managed listed assets into passively managed funds.
Cost cutting and scale aside, the CDC lobby has failed to address a serious flaw with CDC schemes that the DWP itself identified. Back 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. The subsequent government U-turn can only be put down to lobbying: little else has changed, and the risk of perpetrating inter-generational injustice via CDC schemes remains.
In addition, the recent Budget’s move to allow ready access to pension pots’ cash from age 55 unwittingly undermines one of CDC’s technical advantages. Pre-Budget, a CDC scheme’s investment horizon would have been longer than that of an individual DC pot because incoming new members perpetuated the scheme. Consequently there would have been no need to de-risk as members approach retirement, so the scheme could remain invested in higher yielding “growth” assets. But, post-Budget, this horizon is shortened because members reaching 55 will surely want to take advantage of the new pension freedoms and exit the scheme, taking their cash with them.
In conclusion, the pensions landscape remains a muddle. The Budget took a (simplifying) step forwards, but the advent of CDC, via the Queen’s Speech, further complicates the landscape. This suggests a lack of joined up thinking within government… part of the price of coalition politics?
Michael Johnson is a Research Fellow at the Centre for Policy Studies. Twitter: @Johnson1Michael