Hilary Salt says DC is merely a savings vehicle, and argues collective DC would provide a wage in retirement more efficiently
The past decade has seen a seismic shift in the way employers provide pensions, with almost all now having given up on providing any more defined benefit accrual. I don't agree that this outcome was necessary or desirable but to use a football analogy, we have to play the ball from where it is. In most workplaces, that has meant kicking the ball out of the stadium altogether - retreating to providing only defined contribution (DC) benefits and often at vastly inadequate levels. DC pensions have their place and the success of auto-enrolment means that the numbers saving in a pension has increased for the first time in years. But these schemes aren't pensions, they are just savings schemes that provide cash at retirement. The only option members have to turn this into a pension is to buy an annuity - an option that looks stunningly unattractive to the majority of members. What most people need in retirement is an income. Throughout their working life they've received a monthly (sometimes weekly) wage - that's how they've budgeted, paid the bills, saved a bit and bought the drinks in the pub before the match. They need a wage in retirement.
A collective DC scheme would provide a wage in retirement more efficiently. There are three reasons for this. First, charges: a collective scheme can drive down charges. Second, investments: with the fungibility of money meaning that the scheme doesn't have to liquidate assets at each member's individual retirement, the scheme can be more long-term in its investing - using real assets and investing long-term in illiquid assets to generate better returns. But the most important reason is that in a CDC scheme, members share longevity risk. This seems to be the concept people struggle with the most - although it's a concept they grasp very quickly when thinking about using life insurance to cover the risk of early death.
Let's use as an example, someone saving in an individual DC scheme and retiring at 65 and going into drawdown to avoid the high costs of an annuity. They ought to plan on living until 105 (say) if they are to have a low probability of outliving their savings and so they should draw down from their pot over 40 years. But if the member then dies at a typical age of 85, half their pension savings are left unspent.
To put this another way, if one hundred 65-year-olds want to hold a pot to draw down a real income of £10,000 pa in retirement, then saving as individuals (and assuming a zero real rate of return for simplicity) they'd need £10,000 x 40 x 100 = £40,000,000 to safely plan for drawing an income until age 105. But some of those 100 pensioners won't live for 40 years - we expect them to live on average for 20 years. If they save collectively, they only need to save £10,000 x 20 x 100 = £20,000,000. But if they only save £200,000 as an individual, they risk running out of money at age 85 when they might still have another 20 years of retirement ahead of them. It's this magic of longevity pooling that means we need CDC as an efficient way to provide an income in retirement.
You've probably read in the news pages of Professional Pensions that the Communication Workers Union and Royal Mail have agreed to resolve their dispute on the basis of an agreement that commits them to working together to find a way to make CDC happen. I'm thrilled that having to play the ball from that muddy corner of the pitch, they have chosen not to kick it out of the stadium but to use their silky skills to get a better result for our postal workers.
Hilary Salt is a founder of First Actuarial
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