Theo Kocken: Why it would be disastrous to mix pre- and post- retirement members in CDC

As the UK wrestles with how best to defuse its ‘pensions timebomb', collective defined contribution (CDC), versions of which the Netherlands, Denmark and parts of Canada are all using, continues to be put forward as a potential solution.

Supporters say CDC gives savers more predictability about their retirement income, a valuable assurance for DC savers, many of whom might be unsure whether their pots will last through their whole retirement. It also gives employers a way out of the headache of funding defined benefit pensions for employees who are living longer. CDC schemes tend to have a large membership and single investment strategy, driving economies of scale, to the benefit of employers and members.

This combination looks good to the Royal Mail and its 140,000 staff, among others. Both the company and the Communication Workers Union have lobbied in favour of adopting CDC should UK regulation allow it.

But should they be quite so enthusiastic? Our experience in the Netherlands suggests the UK should be cautious about adopting CDC to provide pre- and post-retirement benefits in a single scheme. On the other hand, a collective approach could still work for savers at retirement.

CDC has been running in the Netherlands since around 2000 but the legislation behind it was tightened in 2015 after the crisis exposed the challenges of risk-sharing. When markets dip, someone has to shoulder the losses. In the Netherlands, pension pay-outs have risen far below inflation in most cases, and in many others, they've even been cut.

In lean times, inter-generational discontent festers if one generation benefits at the expense of another. The Dutch experience has shown that this inter-generational cross-subsidisation becomes a political hot potato, as each generation feels losses more keenly than gains.

Understandably, young savers are unhappy about being part of a scheme that's even 10% short of being able to pay out all of its target benefits. That's because their contributions are helping make up that shortfall.  In severe cases, where the shortfall is 30% or more, the scheme might close, leaving the youngest generations to take the hit on a large part of the losses.

Also, the question of how to spread risk and allocate returns fairly between generations makes CDC more complex than it looks. Extensive upfront legal work and regular, sensitive communication with members (especially if schemes have to cut benefits) imply costs could be higher than many expect.

Finally, the Freedom and Choice regime poses another problem. For the two to co-exist, CDC will need clear and robust regulations defining each member's share of the total assets at any time.

Many in the Netherlands now feel a more individual version of CDC would be better for savers. Under collective individual defined contribution (CIDC), savers would still participate in large-scale schemes, collectively investing their contributions before retirement, but the schemes wouldn't smooth out the ups and downs of investments and longevity by potentially pushing deficits onto unborn generations.

Costs are still lower thanks to economies of scale but savers keep their own accounts, making it easy to identify their pension pots. There's also a closer link between what members pay in and the pension they receive.

That's not to say that sharing the risk of people living longer after retirement can't still work. But it's better being restricted to the generation taking their benefits - in other words, spread across 30 years, rather than up to 70 or 80.

Almost all the drawbacks of CDC disappear if the risk is only shared post-retirement. For instance, regulation becomes simpler because there's no need to oversee the balance of risk across a wide range of generations, or transfers in and out of schemes, and there's no need to smooth out shocks over very long periods of time.

The Dutch experience suggests it would be disastrous for the UK to mix risks of contributing and retired members in the same collective scheme. The Dutch are still trying to make amends for this fundamental design flaw.

 

Theo Kocken is founder and co-CEO of Cardano, and professor of risk management at VU University in Amsterdam

 

 

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