How CDC schemes can be a win for every generation

Whether CDC schemes outperform standard DC by 20% or 60% is a matter of assumptions and perspective, but it's generally agreed that: "through pooling of longevity risk, and adopting a higher return-seeking investment strategy, CDC can offer a higher expected income for life than alternative approaches." Those are the words of Legal & General's John Southall in his recent article for Professional Pensions.

With the superior pensions that come from CDC accepted by government, some are asking questions regarding other aspects of CDC design, in particular the volatility of future outcomes and the fairness of various designs with a focus on "intergenerational fairness".

We also think there is confusion between flexibility that a DC pot offers and a retirement income for life – we cannot make a pension as flexible as a pot of money but we have been paying pensions for over a century and people seem to want them!

We are working hard to bring a whole-of-life CDC design that is a UMES (unconnected multiple-employer scheme) into the world and have considered carefully the impact of design features on both volatility of outcomes and fairness between different employers and between the memberships of those employers. We outline below the key design aspects we believe can make CDC fair for every generation.

Contributions converted to CDC pension on cost-neutral terms

The Royal Mail CDC scheme can afford a level of cross-subsidy between its members, with a single contribution rate earning a 60th of pensionable salary. The pension accrual works as it does for DB schemes - the young overpay to begin with but get a good deal out of later life contributions. It's a whole career approach which is right for Royal Mail but not for multi-employer schemes where one employer will not wish to subsidise another employer's membership.To ensure fairness between our unconnected employers we intend to employ a more dynamic approach to pricing. Contributions will be converted into CDC pension on terms which are:

• Age-related – it is cheaper to provide a pension to a younger member than an older member, as their funds will be invested for a longer period before pension is paid. Fairness dictates that this difference is reflected in the pricing.
• Gender-neutral – it could be argued that because women on average live longer than men then a male contribution of £1,000 should buy a higher pension than a £1,000 contribution from the same aged female. The employers we have spoken to are generally keen that £1,000 of contribution buys the same pension for all members of the same age, and therefore gender-neutral conversion factors will be adopted.
• Fully reflective of the scheme experience (level of pension increases) to date -the pricing will fully reflect the level of future pension increases expected. This won't just be reflective of the increases calculated at the last annual actuarial valuation, but will include more recent experience to ensure some members cannot "game" recent market movements.

Regular changes to conversion factors to reflect up-to-date experience are what we refer to as "dynamic pricing".

Investment strategy is pre-determined

We hear a lot of people suggesting CDC schemes need a constant flow of younger new members to be able to maintain the returns-seeking investment strategy that produces the superior member outcomes. Whilst we can see why people might suggest that, it's not true. Members' expected pensions don't fall if the scheme accepts no future members or contributions.

This is because the broad investment strategy is pre-determined, and whilst the trustees will be able to adjust the individual investments as they see fit the overarching strategy will remain unchanged.

A potential CDC investment strategy is outlined above. When members' contributions are converted to CDC pension, they are converted on the basis that the funds invested on behalf of the member will move over time in line with the prescribed strategy above.

This strategy can't significantly change – CDC regulations will require a new section be opened if that were to happen. So, if the scheme were to close to new members or contributions then the scheme would end up invested more in matching assets, but that would be planned and not change the benefit expectations of the existing membership.

There are other issues a CDC scheme would face if it closed to new members or contributions, including having to sell assets to pay benefits and ensuring that the charges on funds were sufficient to continue paying the administrative expenses of the scheme; but there is no fundamental change in the expected benefits of the existing membership.

 As time goes by, we suspect there will be no need for CDC schemes to continue running on with older memberships – it should be possible to transfer a closed CDC scheme into a continuing open CDC scheme.

An indexation approach to adjustments (where possible)

UMES CDC legislation requires adjustments for experience to be made to future pension increases within certain bounds, and if the experience is outside of those bounds then one-off increases or reductions in benefits are permitted.

The benefit of spreading experience across all future increases is a significantly reduced volatility of member experience – members' pensions don't increase far from the expected level except in times of significant divergence from expectation. One-off increases or reductions are highly unlikely.

If you still think intergenerationally unfair – in which direction?

The debate surrounding intergenerational fairness in CDC schemes reminds us of the time that employer covenant was first intended to impact the level of deficit-reduction contributions DB trustees asked of a sponsoring employer. It could be argued both ways whether a strong employer covenant was meant to imply a higher level of employer contributions (because they could be afforded) or a lower level of employer contributions (because employer support could be relied on for longer). Somebody asked this at a pension talk and the speaker was unable to give a definitive answer.  

There are those that think older members are benefitting from, and maybe even exploiting, the existence of younger members in the scheme. There's no doubt that older members will get a great pension from CDC schemes, but there's plenty to suggest that younger members will get an even better deal from joining a CDC scheme:

• The low cost of CDC pension for younger members  – conversion factors will fully reflect young members' term to retirement, and we could easily see younger members getting 4x or 5x as much CDC pension for the same contribution as older members;
• A longer period of CDC "accrual" – whereas older members are likely to have been invested in a DC scheme for a significant portion of their working lives, younger members will benefit from earning CDC benefits (and the additional 30% - 60% pension without difficult investment decisions that represents) for longer.
• The benefits of time diversification – older members benefit from the experience affecting their pension being spread over a number of years, but younger members benefit from experience over a greater number of years being spread across the scheme's lifetime. This can be illustrated with the example of each year's investment returns represented by the roll of a dice. If you throw one dice, there's a reasonable chance your average score will be 1 or 6.  If you throw 50 dice, the "law of large numbers" means the average will almost certainly be close to 3.5. Younger members have a longer time to experience highs and lows in investment returns meaning their annual return is more likely to be closer to the average than older members.

In a world where house prices, university fees and student debts, climate change and AI ( "taking their jobs" ) are all against our young people, let's recognise CDC pensions as the incredible benefit that could be for their generation.

Let's keep educating people on pensions and supporting CDC

The shift in CDC conversation, from "if" to "when will we see mass CDC membership", has been exciting to see. Greater understanding of CDC schemes within the pensions industry is the first port of call.

It means that the benefits and risks can be discussed knowledgably by the professionals that company leaders and pension scheme members trust. HR departments will need answers.

You can try to swim against the tide, but sooner rather than later HR leaders will be coming under intense scrutiny from their pension members. Members in DC schemes will be asking why their pension contributions are not working as hard as CDC schemes do.

There is only so far you can go by arguing for the flexibility of drawdown and of cashing out; we hear people asking for a pension from the pension scheme they've been saving into!

Chris Bunford is senior actuary of GPA and Henry Tapper is chair of AgeWage. Together they write from Pensions Mutual, a platform for a CDC scheme they hope to have authorised this year.