Editor's letter: Could CDC provide a solution to the pension income problem?

The UK’s privatised postal service provider, Royal Mail, is the first in the queue to make use of the new legislation.

Royal Mail set out the contribution rates for the new scheme last year – 6% from members and 13.6% from the employer. Benefits will accrue at separate rates for a cash fund, guaranteeing a lump sum at retirement, and the CDC scheme.

A shadow trustee board is understood to have been appointed and the first contributions, estimated to be at least £500m per year, are expected to start before year end. The company, which was privatised in 2013, closed its £13bn final salary defined benefit (DB) scheme in 2018.

Unions and employer have agreed against a reserve, which means that Royal Mail’s CDC scheme will effectively bet on the equity risk premium over time, with a high allocation to global equities.

In the Netherlands, the new pension system – not ‘pure’ DC as sometimes thought – also has the option to include a ‘solidarity reserve’ in addition to a more flexible option (see column by Tjibbe Hoekstra in this issue). While most Dutch sector schemes are likely to embrace the ‘solidarity’ version, the ‘flexible’ option is more likely to be adopted by the country’s remaining corporate schemes.

Although outcomes are uncertain, WTW (formerly Willis Towers Watson) has estimated that CDC could provide benefits 40% better than a traditional UK DB scheme and as much as 70% better than a DC scheme where the member buys an annuity at retirement.

More flexibility in accrual under CDC allows member assets to grow because it frees asset allocation from the constraints of DB funding requirements. A large and growing CDC scheme like Royal Mail, free from the need to provide constant liquidity, as in a DC scheme, will be able to tap the illiquidity premium through allocations to private markets over time.

But it takes a long time for new pension systems to prove themselves and for stakeholders to adapt, and there is no guarantee that there will be wide take-up of CDC in the UK. The British public sector – with funded and unfunded average salary defined benefits – looks set in its ways.

And even if the benefits of CDC pensions do stack up, will there be a rush of finance directors in the private sector looking to introduce CDC? There is said to be a smattering of interest already from some employers, with unionised companies thought most likely to be open to the model.

But UK plc effectively buried DB pensions in the 2000s, first closing schemes to new accrual and then to all future accrual. It is hard to imagine widespread appetite to introduce CDC where DB plans have been frozen if finance directors now see auto-enrolment minimum contribution rates as a benchmark.

If outcomes are better under CDC, some companies might see an opportunity to level down their contributions, effectively meaning that the benefits of the new scheme accrue to the sponsor rather than the individual.

The retirement phase is where CDC is most likely to prove itself. “The reason CDC always wins is because it very efficiently and effectively hedges longevity risk,” says David Pitt-Watson, one of the leading advocates for CDC in the UK.

He points to one of the main weaknesses of the current auto-enrolment based DC system, namely the lack of any system-wide plan for retirement income. 

This is likely to become an issue of some urgency as a cohort of retirees with significant capital sums comes up against the practical problem of turning capital into long-term stable income at reasonable cost, which has been described by the Nobel Prize winner Bill Sharpe as the “nastiest, hardest problem in finance”.

Annuity rates have been unattractive for many years and despite upward pressure on interest rates there is no guarantee that they will become attractive again soon. Reforms to Solvency II, long planned by the UK government and the subject of some discussion recently, are unlikely to make annuities more attractive. The alternative – drawing an income from coupons and dividends – has always been more of a pastime for the relatively wealthy.

Well-governed CDC master trusts could become a halfway house between annuities and individual drawdown if constructed well, effectively allowing for professionally run collective longevity risk pools with variable benefits. Smart thinking insurers should embrace this idea given their natural business focus on retirement income generation. Others would surely follow suit.

Liam Kennedy, Editor
liam.kennedy@ipe.com