Collective DC is held up by some as the solution to the failings of money purchase as it currently exists. John Lappin tests the arguments
Does the UK’s pensions system mean that investors are erring far too much on the side of caution in both the accumulation and decumulation stages?
That is one of the less well publicised arguments of Chair of Hermes Focus Asset Management David Pitt-Watson who believes that investors and, of course, ultimately pensioners would benefit from a system closer to the Dutch system a form of collective DC that allows older investors to share, and therefore take more risk and get more return from their asset allocation before and after retirement.
Sceptics argue that the direction of UK pension reform is moving in the opposite direction towards individual responsibility, so even if a Dutch-style system were preferable, it will probably never happen.
Hargreaves Lansdown head of pensions research Tom McPhail says that, if anything, big corporate DC schemes are actually upping their bond exposure. Though some better off investors take quite high risks and will embrace more risk-based solutions in retirement, the mass-market trend is towards less risk, possibly encouraged by Nest’s ’low risk, medium risk, low risk’ approach.
He says that for some there may be no realistic alternative and that a bond-based investment strategy from retirement through to death is going to be correct for many, handing over the investment and longevity risk to someone else and ’having done with it’.
He sees merit in some of the arguments in favour of collectivism, but he adds: “That is not the game we are playing. There is little appetite or movement around collectivism. Nest, auto-enrolment, even the state pension changes, look to me like Thatcherite individualism continued.
There are good things about it such as an increased sense of responsibility.”
Standard Life’s head of pensions policy John Lawson says that collective solutions are really not all that different from with-profits. Those who benefited from years of good investment growth do not want to see it redistributed to those who did not. If you overpromise, as happened with endowments, it leads to all sorts of disappointment, he argues.
But it is not just this bitter experience that makes such solutions less likely to take hold in the UK. Lawson adds that Holland has a system of collective bargaining across industries that helps facilitate such schemes. That said, the Dutch have had their share of problems recently.
“In Holland, schemes have safety valves. If investments don’t perform well, trustees can cut the indexation of the benefits or cut the benefits as well. Even in Holland this has been an issue in the last few years. But here socially we are more of an individual society.”
There is little appetite or movement around collectivism. Nest, autoenrolment, even the state pension changes, look to me like Thatcheriteindividualism continued
By and large that is also the Pensions Management Institute’s assessment of collective DC, although it warns of the perils of ’reckless conservatism’.
PMI technical consultant Tim Middleton says: “Most members of DC pension arrangements do not have the confidence to make informed investment decisions. As a consequence, they are commonly risk-averse to the extent that they are unreasonably intolerant of short term volatility. This leads them to avoid investment risk and to opt for more stable asset classes. The extreme example of this is the phenomenon of ’reckless conservatism’ which sees members in their twenties investing in cash funds.
“The PMI believes that this trend towards conservatism will only increase with auto-enrolment.
“It is important to consider the impact of auto-enrolment on DC scheme design. With members joining schemes without having given their explicit consent, there will be intense pressure on trustees and scheme managers to demonstrate prudent stewardship of members’ funds.
This will generally lead to default fund design that seeks to strike a balance between returns over the longer term and stability over the shorter term.
“This is reflected in the design of Nest’s default fund, and it seems reasonable to assume that Nest will greatly influence the design of other qualifying schemes. This will lead to an industry orthodoxy in which default funds which will be the investment vehicle for the vast majority of members avoiding full exposure to the equity market,” says Middleton.
Lawson agrees. “Default funds will have to copy the process and find out who their customer is and that will lead to lower risk not higher risk. When we survey I think we will find they are all lower risk,” he says.
Lloyd Raynor, senior consultant within consulting and advisory services at Russell Investments says: “Intergenerational risk sharing in a Dutch style arrangement sounds great in theory but it is very hard to set the appropriate benefit level to ensure that the older generation doesn’t get ripped off or the younger generation doesn’t get ripped off. It doesn’t work if people move. It may work industry-wide but it is very difficult to set the benefit. If you have a large number of people dying early you can increase the benefit but it is hard to know if those movements are transitional or permanent.”
European consultancy Cardano head of clients Richard Dowell says any move to collective DC would be a significant change of direction for the UK.
“Collective DC would definitely take the DC arrangements in the UK in a different direction. There are a number of differences with the current DC approach, but the key one is ’risk sharing’ between members (not between the sponsoring employer and members as with DB). The trustees of the arrangements would need to bear in mind issues of fairness between different generations of members in the fund, as trustees of DB funds do at present. As the pension benefits would be paid out of the overall pot, pensioner members would need to understand that their benefits could vary with the fund’s investment return achieved, rather than the certainty they can achieve with the DC current approach.
Collective DC does not necessarily mean that you can invest in equities for longer, or that it would be a good idea to do so, as we can’t be sure that equities will always outperform in the long term.”
Lawson says many schemes might embrace a collective approach by trying to use financial instruments to create a sort of synthetic with-profits.
He says: “Maybe we will see the creation of almost defined benefits from defined contribution plans. That is the sort of thing you could do if the risk market will bear the insurance risk and reinsurers bear the longevity risk.”
Dowell says: “There are a number of funds available which more actively manage the asset allocation but innovation is still needed around the management of inflation risk for members to ensure that they can maintain their overall purchasing power. There are many risk management tools used within a DB framework and there is no reason why they could not be implemented for DC. It would be important to ensure clear communication for members so they can understand the implications.
“One potential improvement that could be incorporated into a collective DC arrangement is the ability to buy inflation and interest rate swaps to hedge these risks, as DB schemes do, without selling return-focused assets like equities. At present DC members have to sell return-focussed assets to buy bonds and cash as part of a lifestyle arrangement. Using swaps, which do not require an initial capital outlay, the return-focussed assets could be retained as well as good protection against changes in interest rates and inflation through swaps.”
LCP principal Andrew Cheseldine says the theoretical search for higher returns collides with the reality for the mass of savers.
He asks: “Is it private equity, emerging market equity? There is continuum from passive fundamental indices, quant active, active active, high yield, unconstrained. But this is the real world where people are loss averse. If you are investing on behalf of someone else, if you are a trustee or Nest, you don’t want someone to get half way through and then decide not to be investing at all or not far behind it, going to move into cash.”
Cheseldine says the key is to explain the level of risk in asset classes. He also suggests that in reality people end up diversified with lots of different savings, from DB, DC, the state pension and even buy-to-let, all of which needs to be factored in.
Risk appetite will also depend on what retirement date you want and whether you want to pass on wealth. “People may have four or five pension pots and, by accident, they have a diversified portfolio,” he says.
Cheseldine is arguably most damning in his criticism of collective schemes.
“Collective DC is a very long term with-profits fund. You are putting cross-generational subsidies in both pre retirement and post retirement. If you are buying into this knowing your pension can go down, do you have faith in the actuary who decides that the investment return isn’t good enough? I mention Equitable life. If you don’t want cross-generational subsidies you wouldn’t go near it. There is systemic risk with everyone in this sort of scheme. Collective DC doesn’t reduce risk, it just redistributes it.”
Other pension advisers do not reject the idea so comprehensively, though they see practical obstacles too.
Peter Connell, managing director of Wake up your Wealth Ltd, says: “A lot of people will never get to a situation where they have enough money to manage their fund properly in equities, and then drawdown from it. I am not sure what the ideal is, but some things will help. Fundamentally if you pay 1 per cent less in running costs, you are going to have a bigger pot.”
Connell suggests that it is only really 10 per cent of pension investors that benefit from full wealth management, though he believes some advisers are selling this sort of service to as much as the top 40 per cent at the moment.
While he appreciates some of the benefits of a collective approach, he believes that with too big a group, there is a risk you end up herding a huge number of people in Middle England into very similar plans and that is when critics will start to pick things apart.
He says: “The concept is fantastic if you don’t have as big a herd and if you have a personal pension, a GPP and collective DC for as many people want it.
“If all the solutions had a reduced cost, not 1.5 per cent for something looking like wealth management, but if you get something in the market with good asset allocation, good rebalancing, good risk profiling at 75 basis points, that is a cracking set of solutions. Then you let people chose which one they want.”
With a bigger scheme membership, he says, you cannot meet all the needs of all people all the time. He asks: “Does that mean you shouldn’t do it? No. But it means understanding the restrictions, where everyone understands they have to water down their ideals a little in order to benefit from things that come out of a collective scheme such as good governance and economies of scale, but they have to know they will have to give up some things say on investment choice. It is about setting clear objectives.”
Middleton says the Government remains agnostic about the suitability of Collective DC schemes in spite of enthusiasm from many within the pensions industry. A spokesman adds: “There are no good reasons for supposing that the success of this type of arrangement within the Netherlands could not be replicated here. The introduction of a degree of risk-sharing between members and sponsor would certainly allow exposure to equities well into the decumulation phase.”
Most members of DC pension arrangements do not have the confidence to make informed investment decisions. As a consequence, they are commonly risk-averse to the extent that they are unreasonably intolerant of short-term volatility
Pension consultant Hamish Wilson is a fan and believes there are a lot of issues to be addressed by what he calls raw DC.
He says: “For people of limited means, with the only option being some kind of personal pension, there is little choice from the current picture. Only through some form of collectivisation, can this change. Pooling is the only way to achieve greater financial efficiency and less volatility.
He says that CDC involving no annuitisation allows greater exposure to growth assets and for longer as long as the cash flow of such an arrangement is projected to remain positive for some years to come.
Wilson adds: “CDC does require financial management as does raw DC and any other form of pension provision. The problem with raw DC is this financial management falls on the individual, which is unrealistic for most. Pooling does mean a need for good governance and in the UK this trust structure is perfect for this.
Wilson says pooling would mean fewer schemes with affinity schemes and multi-employer schemes to achieve the numbers required to make pooling work.
But he adds: “Raw DC has been in the UK for some 20 years but has yet to become the dominant form of pension for those approaching retirement today. There is a risk the industry has become too entrenched and influenced by self-interest so that it will take time for the inefficiencies of raw DC to become apparent to enough people to make it a political imperative a solution is found. The real question is must we wait that long when the outcome is so clear now.”