Last month, governments in London and Ottawa moved closer to implementing collective pension schemes, which share risk among members in the hope of proving better outcomes for savers.
But after years of sponsors attempting to rid themselves of the risk imposed on them by their defined benefit schemes, why are risk-sharing schemes coming into favour?
In June, the UK government published its latest pensions bill, which intends to codify three types of pension schemes including shared risk, where “there is a pensions promise in relation to at least some of the retirement benefits that may be provided to each member”.
Comment: Facing the governance challenges of CDC
In response to the consultation paper Reshaping Workplace Pensions for Future Generations, the government believes there is a space between defined benefit and defined contribution pension schemes within which the market can develop risk-sharing solutions.
Given that the legislative framework has yet to be designed, the specific governance aspects that trustees will need to manage are yet to be determined.
However, the overriding challenges trustees can expect to encounter will include control of sharing risk. While the supporters of CDC point to overall population gains – achieved through efficiencies in investment and administration brought about by scale and pooling of risk and optimal investment strategy selection – there have to be winners and losers if risks are pooled.
Having clear guidance and control of exactly who wins and loses could represent a significant governance challenge. CDC entails the potential scaling back of benefits should scheme experience be adverse. The control of the cutback switch could be a sizeable governance challenge.
Communication will also be key. CDC schemes require sufficient scale in order to obtain the investment and administrative gains sought. To achieve this, trustees will need to be able to explain the benefits of what are reasonably complex arrangements to an already disengaged public and be particularly careful to accurately reflect the structures of such schemes without misleading prospective members with references to guarantees.
Adrian Kennett is director at Dalriada Trustees
Meanwhile in Canada, the government is establishing a legislative framework for target benefit plans after a public consultation.
According to documents released by the country’s Department of Finance, these structures are intended to increase the number of employers that can offer employees affordable workplace pensions that provide a predictable retirement income.
“TBPs would promote plan sustainability through their ability to adjust benefits and contributions to help ensure the target benefit is met, and better deal with surplus or deficit situations,” the documents stated.
“Because benefits are targeted and there is flexibility to adjust contributions and benefits, TBPs would not have a solvency funding requirement.”
The model would be open to the 1,234 federally regulated pension plans in Canada, with both defined contribution and DB plans allowed to convert.
Why now?
Collective schemes are already common in the Netherlands, Denmark and Sweden. Stefan Lundbergh, head of innovation at Dutch fiduciary manager Cardano, who presented to the UK’s CDC working group last year, says both the UK and Canada have been paternalistic with a strong history of offering DB schemes.
This was very expensive for employers, with many switching to individual DC schemes.
“What I see happen in Canada and the UK is the pendulum is swinging back, [they] are saying maybe this ‘select your own funds, and instead of building a pension income you are building a pension pot’, might have been a swing too far and they are coming back to the middle,” he says. “I see it as a reaction.”
Tim Middleton, technical consultant at the Pensions Management Institute, says the principal benefit of these structures is that there is more effective risk-sharing between the scheme and membership.
“Rather than the individual having his or her own pot, there is a collective pot, professionally managed, which helps ensure there is less volatility in the returns,” he says.
He adds that the lack of annuitisation means the volatility at the point of retirement is also removed. Lundbergh says although it looks good on paper, in reality these schemes need to be designed to with fairness between the members of the collective.
“If you can solve that then collective solutions have a future,” he adds. “But if you can’t solve it, it will be very difficult down the road because if… people feel distrust, it is very dangerous to a collective system.”
Research done by consultancy Aon Hewitt prior to the Budget changes found that CDC could provide a better income than buying an annuity, with a figure in the region of 30 per cent higher being batted around.
“However, since the Budget the situation has flipped a little bit and the risk facing individuals is they could outlive their savings,” says Matthew Arends, a partner at the consultancy.
“How to manage that risk is a concern to many members. What they are looking for is a retirement income they can look forward to for the rest of their lives, that isn’t an annuity, and CDC is one way of providing that.”
The idea of risk-sharing schemes has been polarising. While the concept of sharing risk and return is appealing, the possibility that pension income could decrease is not. To restore funding levels, a quarter of Dutch CDC plans reported a cut of on average 1.9 per cent in 2012, according to Aon Hewitt figures.
However, commentators pointed out that even though the Netherlands has recently seen a decrease in pension income, they are still receiving more than their UK counterparts.
Despite the suggestion that collective schemes can offer significantly higher incomes than traditional DC, employer interest has been tempered.
Barry Parr, co-chair of the Association of Member-nominated Trustees, says the position of employers can be very different. “Firstly, most employers still don’t have any idea what CDC is, certainly not in the UK,” he says. “Secondly, given the extent of DB, they will run a mile at any likely liability they may have.”
Accessible risk-sharing
The UK government’s response to its consultation, Reshaping Workplace Pensions for Future Generations, laid out four definitions that add more certainty to traditional DC schemes.
Model 1: A money-back guarantee that ensures members get back what they contributed.
Model 2: A capital and investment return guarantee that offers protection at the mid-point of the pension lifecycle, which could secure a guarantee against part of the capital and investment return for a fixed period.
Model 3: Retirement income insurance. This is intended to provide certainty about income in retirement.
Model 4: A pension income builder where part of the contributions is used to purchase a deferred annuity and the rest is invested in a collective pool of risk-seeking assets.
Cardano’s Lundbergh says the final option may pique the interest of more employers, as it offers fairness between members and allows them to come and go as they please. “The pension income builder offers a clearer structure and income stability,” he says.
