A welcome for collective DC
In recent days pensions Minister Steve Webb has got into difficulties on pensions charges, but has also made a positive commitment to collective DC pensions. After a few words about charges, this post explains what collective DC is and why it should be of interest to unions.
At first the minister was against capping pensions charges (as was the last government). But in the face of mounting evidence that excess charges destroy value and a strong campaign from consumers, unions, experts and Labour, he announced a pretty ambitious timescale that would see charges capped in 2014. But now he has had to delay the announcement about what he will do until 2015.
Of course, those of us in favour of a charges cap are disappointed by the delay, but we can also admit that there are genuine issues of detail that need to be got right. It is in any case better to get a cap that will bite not just into auto-enrolment pensions, which so far mostly are low-charge, but also into legacy pensions. In pensions we are always playing the long game, and now the politics seem to point inexorably towards a charge cap. This should be a cause for celebration. (Anyone who doubts that good pensions can be delivered at low charges should read the excellent new report from the Pensions Institute.)
Last year Steve Webb stimulated an interesting debate about what he called defined ambition pensions. In truth there is no such thing as a clear defined ambition pension model in the way we can talk about both defined contribution and defined benefit schemes, so is perhaps not a very helpful label. The consultation paper and the government response examined many different pension models. But opening up debate about other ways of organising pensions other than the two well established models was a welcome initiative.
The TUC’s evidence to the submission identifies collective DC as one of the most promising avenues of exploration in this debate. So what is it? And what is good about it?
Pension schemes are quite simple in their intent. Some combination of the employee, employer and the state build funds up when someone is working and then pay it back when they retire.
But there are many ways of doing this. In a traditional DB scheme members build up a pensions promise that is then met by the scheme when they retire. The scheme collects what it judges to be sufficient contributions to cover these promises. If they cannot meet the promise the employer has to step in to properly fund the scheme.
In a DC scheme each individual employee builds up a savings pot. This is invested until retirement, when it is turned into a regular pension income by buying an annuity from an insurance company.
One important way of understanding the differences between pension schemes is to think how they deal with the different kinds of risks involved in building up retirement income.
In a DC scheme the individual bears the investment risk. How much they have to turn into an annuity will depend on not just how much they and their employer put into the scheme but how well their investments perform. If you put all your money under the mattress it will maintain its cash value, but inflation will eat away at what it will provide. If at the other extreme you put all your money into highly speculative investments, you might get a fantastic return well above inflation, but on the other hand you might lose everything. Neither of these are sensible strategies for pensions investment, but they do illustrate the trade-offs. You need to take some risk to get a decent return, but if you take a lot of risk the outcome is much less certain.
When you retire you face a new area of risk. You do not know how long you will live. You cannot know therefore how much you can afford to sensibly take from your pension pot as you risk running out before you die or failing to get the full benefit by taking too little.
You also continue to face inflation and investment risk. Annuities transfer some or all of these risks to an insurance company who by providing annuities to very many people pool individual longevity risk, but have to make an intelligent guess about the average longevity of those retiring.
Inflation risk can be managed in different ways. The most popular annuities are fixed rate. You hand over your pension pot and get the same amount of cash each year until you die. But you can also buy an inflation linked annuity. You will start off with a lower pension but at least it will keep up with inflation.
There are all kinds of problems with the market in annuities, but even if it worked well buying a guarantee of future income is expensive. £100,000 will buy a 65 year old a fixed income of just £6,000 a year. The insurance company cannot take investment risk as it must be able to meet its promise. No-one else will. In a DB scheme the employer stands as the guarantor, DC schemes do not have one.
The advantage of a collective DC scheme is that it shares risk among members. Risky investments can produce volatile outcomes, but if these are shared between members then outcomes can be smoothed. The lucky share their good fortune with the less fortunate.
Collective DC schemes can also provide retirement income directly without using annuities. Members trade better outcomes for the guarantee provided by an annuity. The great champion of CDC is David Pitt-Watson. In his defence of CDC he writes “The Government actuary estimates that, for the same cost, a CDC pension will be 39 per cent higher than those currently offered by the insurance industry.”
The ABI’s outright hostility to CDC strikes many people I know as well over the top. I won’t respond to their arguments here as the estimable Con Keating – a guest blogger here from time to time – demolishes them at Henry Tapper’s blog.
But let it be said here loud and clear. Unions will have noticed that one reason the ABI give is:
4. CDC requires a collective labour market
Unless the Daily Mail has had a Damascene conversion to collectivised labour markets, it may want to look more closely at CDC. CDCs in The Netherlands are built on the collective model of employers, unions and employees agreeing all major labour market decisions together. CDCs are heavily unionised with senior union officials having more say over how an individual’s contributions are invested than the employee.
This statement (which actually – and perhaps unfortunately – is not true) reveals a straightforward anti-union prejudice.