The challenges for retirees have seldom been greater. Unlike the days when purchasing an annuity was commonplace for defined contribution (DC) savers, and many could rely on a defined benefit (DB) pension for guaranteed income, retirees now shoulder the bulk of risks such as longevity.
These risks have been transferred from institutions – such as employers, the state and financial services providers – to individuals, as the Institute and Faculty of Actuaries (IFoA) explored in detail in its report entitled The Great Risk Transfer, published in April.
The great risk transfer
Richard Butcher, managing director of PTL, a professional trustee firm, explains that, aside from stock market volatility for those in income drawdown, there are three main risks that retirees face: longevity risk, cognitive decline that affects the ability to make good decisions, and the risk of over- or under-spending in retirement. “Any solution should be designed to mitigate these risks to savers,” he says.
Collective DC has faced significant opposition from stakeholders across the financial services industry, where it is accused of being a Ponzi scheme, risks unfair intergenerational transfers and doesn’t pass the ‘don’t invest in what you don’t understand’ test. However, a growing number of voices are emerging in support of it.
Fidelity says it is considering CDC as an at-retirement solution for its master trust and the IFoA believes collective defined contribution (CDC) could be used in the decumulation phase, when pension savings are converted to retirement income, to manage the longevity and investment risks savers face in retirement.
Many in the pensions sector, including trustees and sponsors, agree that existing retirement solutions in decumulation are inadequate for individuals to manage these risks and believe CDC could fill that gap. The UK is legislating to facilitate CDC schemes and secondary legislation is expected to be consulted on in spring 2021, although further rule changes would probably be required for at-retirement versions to be made possible.
For Barnett Waddingham principal Esther Hawley, CDC could potentially help to share or pool risks among retirees. She explains: “DC’s major weakness is that members bear all the risk individually: members are not necessarily well-equipped to handle these risks themselves, and they get none of the risk- reduction benefits that pooling risks can bring.”
Independent Trustee Services (ITS) director Dinesh Visavadia says CDC provides an opportunity for collaboration between employers and to comingle risks. “If we can get a big enough population, different segments of the population with different mortality variation, then it is possible to pool,” he adds.
One argument for decumulation through CDC is that retirees could get an uplift in performance because they can invest in higher- return asset classes for longer than individuals can through income drawdown. Unlike drawdown investors, retirees in CDC schemes would not have to hold back cash to protect them from ‘living too long’.
Analysis from Willis Towers Watson predicts that an at-retirement CDC offering could provide sustainable income 57 per cent higher than that from income drawdown and 49 per cent more than an annuity.
It would also ease the complex decision-making that individuals face. “Freedom and choice which was introduced in 2015 is completely in contradiction to the default arrangements in DC,” says Visavadia. “People in the industry are thinking a little bit harder about this, and CDC has a good place somewhere because a lot of people are not equipped to make decisions.”
PTL’s Butcher adds: “CDC would take out of your hands that complex decision around how much to draw out as income. You get whatever you need for as long as you live – as long as they can do their actuarial calculations correctly.”
However, there are several challenges to introducing CDC in the decumulation phase, whether it be for trust-based schemes or master trusts.
As Barnett Waddingham’s Hawley explains: “Introducing any form of risk sharing gets very complicated very quickly, and is likely to be unappealing for sponsors who have already moved towards DC. Sponsors who have yet to take that leap may be more open to a scheme design which is mostly DC but on top of a basic CDC element providing, for example, a lifetime income from age 85.”
There are several challenges that first movers would need to work through.
“While CDC might have advantages, it’s not clear that the benefits outweigh the effort needed to surmount the barriers,” says Hawley.
Master trusts considering CDC in decumulation would have to look hard at how to design it, how it will work when it is up and running, and how to explain it to people who are approaching retirement. While it can smooth investment returns through pooling, there is still a risk that retirement income can fall in a CDC scheme.
As Willis Towers Watson senior director Simon Eagle says, CDC can increase “variables”, as there is a degree of uncertainty about what an individual’s pension level will be in the future.
“I think trustees and sponsors will want to understand that more and have some reassurance that CDC won’t be excessively volatile or that there won’t be an excessive risk of cuts to pensions. People will need to understand that there is not a guarantee so future pension levels are uncertain,” he says.
ITS’s Visavadia suggests simpler payment systems and simpler taxation of pension income could help CDC take off.
Another challenge with CDC is the risk of drawdowns when individuals are told their pension income could be reduced, explains Visavadia: “That is the biggest stumbling block: how can we overcome those drawdowns [when markets are down], and how do we communicate that in a way that people understand.”
Butcher has reservations around the ability to safely predict the amount of money needed. “The CDC could be overly cautious and prudent, which would seem to be a sensible way forward,” he says. “But that means taking money out of the pockets of people who are members of that CDC scheme. “The other concern is that with this mechanism, you need to have an actuary or a team in the background working out what is the sustainable level of distribution – which costs money.
So, operationally, it’s a more expensive option.”
He also is sceptical about research suggesting that CDC would deliver a higher return because it would have higher economies of scale. “CDC would have economies of scale but
not more than a pure DC scheme,” he says.
Many agree that CDC decumulation would need to be offered as an option for individuals and not the only path at retirement, because different people have different needs and wants. However, this brings other challenges – as Darren Philp, director of policy and communication at Smart Pensions, says, for CDC to really work scale is needed.
“One of the big things that I worry about with CDC is, if it’s not within a default, how do you get the throughput of members, because you need that constant flow of new entrants to make it work,” he says.
Another option could be to have a basic approach to mortality pooling. Hawley explains that for
each cohort of retirees – potentially a bucket of a few years in order to ensure sufficient scale – on a member’s death a portion of their remaining DC pot would be redistributed amongst surviving members of the cohort.
“Surviving members would benefit from these mortality credits each year, while retaining control over their own individual DC investments, and potentially also allowing a portion remaining to pay out as a bequest,” she adds.
Master trust buy-in
For decumulation CDC to really take off in the UK, it will arguably need master trusts to play a role as they have the scale of assets and membership.
However, Philp casts doubt on whether master trusts will take the lead – in part because pot sizes are too small.
“There is an increasing appetite to look at CDC, but it will be some time before it really comes into the mass-market master trusts,” Philp argues. “I think it will initially come through the decumulation side because it means that people can stay on with their money still growing in retirement with less volatility, which is not quite the Holy Grail, but it’s where we need to get people to.”
He expects that, as pot sizes grow, there will be more demand and more of a need for a pooled CDC solution.
Willis Towers Watson’s Eagle is more positive on master trust take up.
He says: “It’s hard to predict, but if they get it right, and if employees see the advantages of CDC, then I hope maybe five or 10 years from now it will become quite big and there will be some quite sizable CDC decumulation- only master trusts.”
So far, Royal Mail is the only organisation to have openly embraced the CDC model. But with support building in the pensions sector for innovative new approaches closer to DC and legislation imminent, more providers could soon step up to explore this new pension model.