Gandy Gandidzanwa & Itai Mukadira
Many have asked, if Defined Benefit funds are an onerous financial burden to employers, and traditional Defined Contribution plans have consistently fallen short of the mark, is retirement funding doomed?
Our first paper this year, “4 Decades On – How Well has the Corporate Defined Contribution Pension Regime Fared?”, highlighted the systemic failures of the traditional Defined Contribution regime. We followed that up with a second part to it where we proffered some low hanging solutions to address some of the shortcomings of the system. That was then followed up with a focus on umbrella funds as an integral part of addressing the main challenges of the DC plans. Subsequent to that, we addressed some other structural issues of the industry. We were also on record, along the way, categorically saying, DBs, just like steam-powered locomotives, would not be coming back.
Now, as we come full circle, we bring with us the concept of Collective Defined Contribution systems, CDCs. Could they be the much-needed saviour?
Already growing in popularity in the Netherlands, Denmark, Sweden, and Canada – and very freshly minted into law in the UK, what exactly are CDCs?
Better of Both Worlds?
The idea behind a CDC scheme is that, whilst members are building up benefits, the contributions are defined, like a traditional DC scheme. However, by pooling assets and liabilities, the scheme offers members a target defined pension benefit which is paid for life from the scheme when the member retires. Unlike a standard DB pension scheme though, the level of the defined pension benefit is not guaranteed – it is just a target.
Let us explain.
CDC plans combine elements of DB and DC plans as they strive to offer the better of both worlds. Some have referred to them as “hybrid retirement plans” – we fear though that the term can mean different things to different people, so we will steer away from it here and just call them by what they are, Collective DC plans. “Collective”, as opposed to “Individual”, in reference to the pooling of assets and sharing of risks, in contrast to the traditional DC system with its focus on members’ “individual” savings pots. In the Netherlands, the torch-bearing front runners of the system, the term “Defined Ambition Approach” is the more commonly used one.
For employers, CDCs avoid both the open-ended liability and volatile funding costs nature of standard DBs by setting fixed employer contributions – correcting that drawback of DB plans. CDCs are self-sufficient, so do not rely on further contributions from employer to pay for any past service pension liability shortfalls. They, effectively carry the same benefits to employers as those of standard DCs.
For members, CDCs pay benefits in the form of periodic retirement income, rather than lump sums at retirement.
Thus addressing the shortcomings of conventional DCs of being a retirement system that is absent when a member is actually in retirement – arguably, a time they need their system to be working for them the most. Members’ contributions, just as those of employers, are a fixed percentage of salary too. CDCs also pool both investment and longevity risks across participants, correcting the other key weaknesses of standard DC plans.
Further, CDCs also allow pensioners to de-risk over time instead of buying an annuity as a once-and-for-all event – a weakness of the traditional DCs that effectively reduces the entire system to a game of chance and luck as the resultant pension is dependent largely on the prevailing annuity rates at the point of a member’s retirement, and that point only.
The absence of guarantees, in comparison to annuities from insurers, frees up CDCs to invest in a wider range of higher-return assets than insurers would be comfortable with being exposed to.
Delaying de-risking as far off into a member’s retirement as is possible means that assets remain deployed in growth-seeking investments, allowing members to benefit from future market growth through enhanced pension increases.
The pooling also enables funds and members to save for an average life expectancy rather than a random one that can take either of the two extremes – either very long, or very short.
Cost-Effective Solution
That CDCs are intentionally designed to come with no guarantees enables them to provide lifetime retirement income in-house with no portion of members’ assets given away to cover insurers’ buffers, actuarial reserves, statutory capital requirements, expenses, and profit margins. This results in more of members’ investments going towards what they have been saved for – providing them with an income in retirement. Besides, even without all the loadings, insurers are naturally conservative investors who invest very prudently to manage the risk of failing to meet the payments when they fall due.
Size matters when it comes to CDCs. Their design is such that the most benefits are reaped cost-effectively only by schemes with very large memberships, making umbrella funds the “natural homes” for CDCs. This is a piece of good news for those of us who have been advocating for the consolidation of the industry. Housing CDCs under umbrella funds would also address the challenges of having to deal with transfers-out when members change jobs.
While there is no immediate consensus on the exact minimum size, funds with 5 000 members, it has been projected, would start to reap the benefits of CDCs. Minimum sizes of 10 000 members though are regarded by many as more optimal – with anything over and above that considered an absolute advantage.
The rationale is that the greater collective size of a CDC fund would allow for a wider diversification of investments and a greater ability to manage investment risk, hence achieving more stable outcomes.
Aon, one of the “Big Five” global employee benefits advisors, found that the median outcome for CDC savers is one-third better compared to traditional DC pots that are de-risked and then invested in an annuity. UK Government-commissioned studies have showed improvements of similar magnitude. But perhaps the most decisive findings are those based on research conducted by another of the world’s largest employee benefits advisory firms, Towers Watson Willis, who reported staggering improvements of up to 40% and 70% relative to the DBs and conventional DCs, respectively.
More Stable Outcomes
Other benefits include, firstly, more of those emanating from longevity risk pooling. Individual members cannot accurately predict how long they will live. By leaving them to manage their own funds at retirement, conventional DCs have, disappointingly so, tried to make members into amateur actuaries capable of making complex financial decisions. Pooling enables the efficient collective management of the longevity risk, harnessing the “magic of averages” to pay a lifelong income to all members. In this way, the CDC system mimics the key benefits of an annuity — the assurance of a regular income for life, without the cost of exorbitant annuity rates.
Secondly, removing the need to purchase a separate retirement income product may also reduce cost leakage to third-party providers and advisors.
Thirdly, the costs of running an aggregated fund would be proportionately less than the costs of running the sum of individual pension pots, thereby also helping boost the overall benefits achieved.
Furthermore, CDCs also deliver more predictable outcomes for members compared to traditional DCs. The pots available to individuals in conventional DCs are dependent on highly unpredictable market performance in the period leading up to retirement. This is still so even with effecting some de-risking strategies towards retirement.
CDC designs also mean fewer volatile outcomes between cohorts of members. With the traditional DCs, market volatility can lead to very different outcomes for individuals with otherwise identical circumstances retiring only a few years apart.
Significant Societal Benefits Too
Needless to say, a more predictable retirement outcome is a certain morale booster for employees, immediately increasing productivity – creating a happier and more attractive work environment. It also eases the pressure on employers, who see it as their duty to help their employees achieve a decent pension.
By providing greater predictability of outcomes compared with the traditional DCs, CDCs reduce the likelihood of people needing to work beyond their preferred retirement date. A benefit first, directly to members themselves for health reasons, and secondly, to employers as it allows companies to replace their retiring employees with much younger employees that are likely to be a lot more productive.
For society at large, the benefits are just as numerous, but key amongst them are those associated with investments. CDCs, by design and the absence of the need for de-risking as members near retirement, allow for much longer-term investment horizons than standard DCs. The pooling of not only assets, but investment risks as well, means CDCs can deploy real “patient capital” into illiquid investments, providing the much-needed funding into infrastructure and innovative firms.
What to Watch Out For?
This thought-piece would not be complete, and we would have failed in our duty, if we do not also shed light on some of the potential issues that the industry will need to bear in mind. Firstly, fixed contributions mean that if investment returns are poor, pension levels will need to drop, leading to income volatility for pensioners. The design aspects and policy framework, however, would be such that the probability of this happening is kept to a minimal. One such mechanism would be to say award increases based not on annual returns, which might be volatile, but on smoothed annualized returns over rolling multi-year periods.
Secondly, risk-sharing entails cross-subsidisation across different cohorts of memberships – for instance, the younger members vs the old. With large enough schemes however, the degree of potential subsidisation can be greatly reduced.
CDCs also come with an inherent element of inflexibility and limited freedoms for members. One could argue though that this is only a small price to pay for all the significant improvements in benefits that CDCs bring about. Creative scheme designing could also be such that the core benefit is what is designed around the CDC framework, while any added rider benefits would come with as much choice for members as is possible.
The collective nature of the schemes require that the entire system is seen as fair by members. The policy framework and rules of participation should be sound and firmly rooted on fairness. No loopholes should exist that would result in one cohort of membership endlessly subsidizing another. There is also an elevated need to provide absolute clarity on the nature of the promise being made and the benefits being undertaken to be provided. Further, such a collective system needs good communications and should, as far as possible, set out guidelines about how trustees would intend to deal with unexpected events.
Conclusion
The ultimate retirement benefit a member secures is largely a function of four key elements – the contribution rate, the period over which the contributions are made, the returns earned on the investments, and the expenses of running the fund. Where increasing the contribution rate is generally unpopular, and the period over which contributions are made can only be increased minimally, the only hope of significantly improving the chances of members retiring more comfortably lies in the remaining two.
CDCs, with their ability to be invested in growth-seeking assets for longer, including illiquid investments, and housed under large umbrella funds that bring forth real economies of scale, seem to be the only way out if the industry is to get anywhere closer to delivering on the dream of getting more members to retire financially independent.