For CDC to succeed, providers, employers and members need to understand and be comfortable with the pooling of risks, writes the Pensions Policy Institute’s Tim Pike.
Pooling of risk is a tricky business. We would like, as an industry, to be good at this, which is a noble ambition, but complications will inevitably limit how effective we can be.
The sharing of risks operates at many levels, a balance between groups and a balance within groups.
The mass market of the workplace pension space is currently dominated by master trusts offering individual defined contribution (DC) solutions without risk pooling and without offering an income in retirement. Instead, they leave members with some very big decisions to make at retirement.
This space is evolving, with scheme consolidation on the government’s agenda and default decumulation options emerging, which will mean that members will be able to ‘skip’ that big retirement decision.
Neither of these developments necessarily leads to risk pooling among members. Some of the decumulation approaches will offer risk transfer from a member to an insurance company through annuitisation. This comes with a high price tag, paid for by the member, as capital requirements and shareholder dividends mean offering guarantees is an expensive business.
The ‘social contract’ of CDC
Within a collectivised framework, the ambition is to offer a fair sharing of risk that reflects the risk tolerance and capacity for loss that each party may have. In a workplace arrangement, there is a need for fairness between members, or else there will be friction on many levels. This fairness needs to operate technically, where actuaries will pore over the numbers, and it must ensure members feel they are being treated equitably.
Multi-employer collective defined contribution (CDC) pension schemes are seen as an opportunity to offer both fairness and risk pooling to the workplace pension market. This does not offload the risk but rather seeks to share it.
The risks that can be pooled between members are considered by the experience of different members within a scheme. Financially fortunate members will distribute their good fortune with others while being cushioned against their own poor fortune. This is the social contract of a CDC scheme.
For members to ascribe to this CDC social contract they must believe it to be in their best interests. To that end, it must be more appealing than the alternative. This generates a challenge around perception as the test now becomes not whether it is, but whether it is perceived to be.
The proposed UK model for multi-employer CDC schemes involves shared indexation. This involves all members receiving the same rate of uplift to their benefits - or cut, should it ever come to that.
However, sharing investment risk through shared indexation, under theoretical conditions, is provable to not be mutually beneficial to all members. Some will end up subsidising others beyond their risk pooling.
Fairness in DB, DC and CDC
Now, before the industry gets up in arms that this new scheme type is unfair, so are the two incumbents already operating in the space.
It would feel unreasonable to demand that CDC delivers with perfect fairness, when we accept alternative versions of unfairness elsewhere in the system.
Defined benefit pension schemes offer considerably more valuable benefits to older members for the same flat rate. DC pensions, meanwhile, will always see those with larger pots subsidising the running costs of those with smaller pots.
These are all accepted with varying justifications, of which two are particularly notable: that an individual will be both ‘subsidiser’ and ‘subsidisee’ at different times, so they can be regarded as subsidising themselves over the course of their membership; and that membership is more valuable than not being a member.
In a scheme that offers the benefits of delivering an income in retirement and risk pooling between members (while not including an unappetising financial cost on either an employer or an insurer to guarantee benefits), it would feel unreasonable to demand that it delivers with perfect fairness, when we accept alternative versions of unfairness elsewhere in the system.
The potential remains to be subsidiser and subsidisee within a scheme over time, and this is incumbent upon the proliferation of CDC schemes and retention of members. Both of these will be considerations for any new scheme seeking authorisation to operate.
In a workplace setting, the value of being a member is generally maintained through employer contributions. If you wish to make alternative arrangements you would need to forego this money, and this would leave a member worse off overall.
This would suggest it is fair enough to be a member. It now comes to weighing the benefits of the social contract: would you share the dividends of your financial luck with others?
Tim Pike is head of modelling at the Pensions Policy Institute.
