What are CDC pensions and why are they a good thing?
There is growing support for “going Dutch” with pensions. Last week Rachel Reeves backed so-called collective defined contribution (CDC) pensions in a speech to the Resolution Foundation. This weekend Pensions Minister Steve Webb got a good showing in the press for the Queen’s Speech Bill that will allow CDC schemes to be set up in the UK.
So for those new to this debate this post asks “what are CDC pensions and why are they a good thing?”
The UK mainly has two types of pension. Once most people were in defined benefit (DB) pensions. This is how public sector pensions still work, but are now a minority in the private sector. Members of DB schemes know what pension they will get. Each year that they work and contribute to a scheme they build up the right to a specified amount of pension in retirement. Employer and employee contributions are set at a level that aims to fund this pension promise, based on assumptions of how well scheme investments perform, inflation levels and how long scheme members live. If these sums are wrong, the scheme still honours the pensions promise as the employer must underwrite this risk.
In most of the private sector, such DB schemes have been replaced by defined contribution (DC) schemes. These are essentially a tax privileged savings scheme. Members build up their own pension pot. Its size will depend first on how much they and their employer contribute, and secondly how well the scheme investments perform. In DC schemes the individual saver bears the risk (although new smart DC schemes such as NEST have developed sophisticated ways of reducing risk and keeping charges low). When they retire members need to turn their pot into retirement income. There are rules about how this should be done – with most retirees compelled to buy an annuity, at least until the Chancellor swept away this rule in the Budget from next April
Annuities are an insurance product. You hand over your pension pot and in return an insurance company promises to pay you a regular guaranteed income until you die. But annuities are seen by most people as poor value. A £100,000 pot buys a 65 year old a fixed pension of just £6,000 a year. And that is from a best buy table – most people will do worse than this as they do not shop around (though those with poor health can do better).
Annuities appear to provide poor returns for a number of reasons. There is undoubted market failure and many customers have been ripped off. There are also particular problems caused by prolonged low interest rates and the impact of QE on financial markets. The standard annuity provides a guaranteed income – and guarantees are expensive, particularly when there is little risk-free return around. But probably the biggest problem is that people underestimate how long they are likely to live. If you think you are going to die in ten years, then an annuity that has been designed to provide twenty years income on average will look poor, even if the other factors went away.
By abolishing compulsory annuitisation the Chancellor was making a calculated shrewd political move. But he put nothing in its place. The one huge advantage of annuities is that they provide what most people want in retirement – steady income until death. They pool what is known as longevity risk – or in plain English, those who do not live as long as expected subsidise those who live longer. This is a classic demonstration of the insurance principle. If the move from DB to DC schemes individualised pensions savings, the Budget has now also individualised the way that people turn their pension pot into post-retirement spending.
At the other end of the coalition Pensions Minister Steve Webb has carried on the approach of the previous government and largely worked on the basis of consultation, rather than pulling badly thought-through party-political rabbits out of Budget hats. That is not to say we always agree with his conclusions, but we have always had a voice in the debate.
He started a discussion on what he called “defined ambition” pensions by floating a number of different ways of organising pensions somewhere between the collective employer under-written DB model and the individualised world of DC. Meanwhile there has been growing interest among pensions experts in the CDC model common in the Netherlands and Scandinavia – spearheaded by David Pitt-Watson through the RSA’s Tomorrow’s Investor project who has brought together a loose alliance of the friends of CDC (including the TUC).
CDC pensions can be best thought of as DB pensions without a promise and without an employer guarantee. Instead the risks (and benefits) of investments or longevity not turning out as expected are shared between scheme members. Like DB pensions all savings are paid into a pool, with all pensions paid from the same pool.
Unlike DB there is no pensions promise. Instead, CDC pensions have a target pension that they seek to pay, though unlike most annuities the intention is that benefits are indexed. There is of course a risk that pensions will not increase or might even decrease in bad years, but in practice in Holland and in modelling based on UK conditions this is both unusual and does not result in big cuts. This is why more and more people are starting to call CDC pensions ‘target pensions’ (see here for another description of how they work).
CDC pensions are likely to provide better returns than DC pensions – up to 30 per cent some models suggest. This is for a number of reasons. First they need to be big to share risk efficiently and this results in economies of scale. Second as there is one central savings pool from which pensions are paid some contributions can be used to pay pensions without the frictional costs of investing. Thirdly target pensions avoid the costs of the guarantees in annuities and allow less risk-averse investment strategies.
All pension schemes involve trade offs, and CDC schemes have critics. The last Labour government came out against them on the grounds that the risk sharing between pensioners and those contributing – particularly younger workers ran the risk of transferring wealth from young to old. This is not a negligible issue, but other pensions schemes manage to share risk efficiently, fairly and effectively. It is a reason to ensure that CDC schemes are not-for-profit trusts and that they have the highest levels of governance combining expertise and worker voice.
And while CDC schemes do provide better returns, no pensions architecture can compensate for inadequate savings. To get decent pensions we need bigger contributions.
We should welcome the Bill to be announced in the Queen’s Speech. But we also need to go further. Particularly at a time when the Chancellor is pushing pensions saving away from the collective, we need a strong public policy push to not just allow CDC pensions to be set up, but to make sure that they are and that people start to save in them. I am sure that there are many employers who would be happy to auto-enrol staff into a CDC scheme, but I am less convinced that any will want to be the first to set up a scheme.
We need not just a change in the law, but a new alliance of government, unions, consumers, and progressive employers and pension interests to make them a reality.