In recent years, a lot of effort has gone into making it as easy as possible for people to build up defined contribution (DC) pension savings without the need for them to make any real decisions – auto-enrolment means they join a workplace scheme at a default contribution level, and default investment strategies have been designed in the knowledge they will be adopted by the majority of individuals.
However, when it comes to accessing that pension, the onus passes to individuals to make decisions and they are faced with a difficult choice between a few products. Lump sums do not provide long-term income; insured annuities do, but data shows that perceived high expense lead few to purchase them. And so, drawdown is often the de facto choice individuals make at retirement, which prolongs the need for retirement decisions that they are often ill-equipped to make.
A Collective Defined Contribution (CDC) decumulation product would allow the purchase of an income payable for retired life, at a variable rate. This would be similar to purchasing an insured annuity but with a crucial difference – there would be no guarantee, insured or otherwise, of the level of income. Instead, the CDC scheme would invest more heavily in growth assets, especially in the earlier years of retirement, and would collectively share risk across members and over time, with the expectation of providing a higher income than could be provided by an annuity.
We’ve estimated before (in our 2020 guide to CDC) that this greater investment freedom could lead to 50% higher expected retirement income – or more if accumulation investments are also adjusted accordingly in the run up to retirement – and this is the main appeal of a CDC product compared to insured annuities.
This income would be spread over an individual’s retired life - without the need for them to make the difficult decisions faced by those in drawdown to balance drawing an income with the risk of running out of money. While an individual could mirror the investment strategy and initial pace of drawdown to try to match a CDC decumulation product, because they are unable to pool longevity risk they would leave themselves with a broadly 50% chance of running out of money before they die. This is clearly too high a risk for most individuals. If an individual was to target a low likelihood of running out of money, they could take a much lower level of income – but for most people, this would turn out to be overly cautious. This is the problem with pension products which do not pool longevity across people.
The spreading of risk in a CDC scheme would be done by gradually adjusting the level of increase applied to each pensioner’s income each year. For example, an individual might buy a CDC pension initially targeting CPI increases, and if assets outperform by 10% in a year, this could lead to an increase of CPI +1% in that year and to be targeted in all future years, subject to any readjustments in future. Conversely, if assets underperform, increases could be reduced or income could even be cut. Adjustments would also need to be made for changes in member lifespans versus original expectations. These assessments would be made by trustees having received actuarial advice.
While this form of investment risk spreading facilitates cross-subsidies between one generation and the next, in the way that it ‘smooths out’ good or bad luck with investment markets over time, these cross-subsidies are typically limited for two reasons. Firstly, a decumulation-only product would have an older average member than a whole-of-life CDC scheme and so at a particular time would spread experience over just one generation of pensioners. For a new pensioner buying a CDC pension, the purchase terms would be set so that the expected long-term value of CDC income equals the purchase price, so that past experience does not affect the income of the next generation of pensioners.
Secondly, we suggest that the investment strategy of a CDC scheme should require derisking as the pensioner membership ages to ensure it remains sustainable – ie retaining an acceptable level of variability of income levels - if the flow of new joiners reduces or the scheme closes. This means that older members’ incomes are supported by lower-risk assets, which marries up with the fact that they are exposed to less variability of future income levels (ie because changes to pension increases have less of an impact on them). This can be designed in such a way that the investment risk exposure to each individual is close to that if they were to invest the money in the same way themselves.
What this risk sharing means from an individual’s perspective is that their expected level of income is higher than if they were to purchase an insured annuity or drawdown prudently, with the chance that their money subsidises other people if they should live shorter than expected – so that, if they are the ones who live longer than expected, they continue to receive an income when they need it.
Looking further at design choices, the CDC decumulation-only product could come with options at retirement. For example, different levels of target increases, with higher initial income if target increases are lower. Most insured annuities purchased these days are flat, non-increasing annuities, and so we would expect some demand for a CDC product with no target increases, but which applies some increases/reductions based on the scheme’s experience.
Another option is for a spouse’s pension payable contingently from the member’s death. We can also see the appeal of a minimum pension payment period, for example, five years, to ensure there is a minimum value for money for the retiree’s dependants should the member be unfortunate enough to live for only a short retirement.
Finally, individuals could choose to put only part of their DC savings into CDC. There could be a large degree of flexibility; while a popular option might be to take 25% as tax-free cash and 75% as CDC income, an alternative would be to put some of the 75% into drawdown to allow periodic access to larger lump sums in retirement to supplement the CDC income. For a DC saver with savings of say £100k, a CDC income could well be the best option for them to purchase an income for a satisfactory retirement.
So CDC decumulation-only would be a product that provides an income in retirement, expected to be higher than an annuity through greater investment freedom, managed by trustees rather than individuals, and payable over the member’s life no matter how long they live.
However, pensions management is not easy and no product is perfect. The challenge with CDC is the variability in the income rate. This variability will need to be explained to individuals in an unbiased way and which allows comparison between competing products, under the new regulations to be developed by DWP. And the scheme will need to be governed by the trustees to a high standard, under the watchful eye of the Pensions Regulator, to ensure no bias in income levels.
We see great potential in new CDC products to boost the options available to DC retirees and look forward to working with the industry further on these.
If you would like to discuss any of these points, please contact your WTW consultant or one of our CDC specialists listed below.
