There is a consensus forming across party lines about the merits of Collective pensions. They will feature as a principal component of the Queen’s Speech today; the Labour Party last week also committed itself to the concept.
But, at best, the claims for collective pensions are much less clear cut than advocates claim (and, in many cases, made null and void by the March 2014 Budget reforms); at worst, they may exacerbate intergenerational differences and hand out prejudicial outcomes to the lower paid.
What are Collective pensions?
Over recent decades, there has been a significant decline in the availability and membership of Defined Benefit (DB) pension schemes, under which employees are guaranteed a certain retirement income by their employer. In their place, employees tend to be put on Defined Contribution (DC) pensions. Under DC, members save individually and carry all the risks individually, including investment performance risk and longevity risk.
In contrast, Collective Defined Contribution pensions (CDC) are a means by which members of a pension scheme save not individually but together. As such, investment risks are pooled across all scheme members and across generations. When someone retires, their retirement income is paid out of the asset pool.
Do Collective pensions live up to their claims?
Two main claims have been made of CDC: first, that that they will provide more retirement income; second, they will provide certainty of retirement income. It is not clear whether either is necessarily true.
More retirement income?
Various figures have been knocking about as to the potential gains to a saver through a CDC rather than a traditional DC. The Department for Work and Pensions (DWP) and the RSA have made rigorous assessments of the gains. People tend to cite 35% to 40% (though the DWP’s central estimates in 2009 were 20 to 25%).
These gains however typically include a number of assumptions that – especially in the light of reforms enacted in the March 2014 Budget – are worth thinking further about.
- There is often an assumption that the person on a DC buys an annuity – but the person may not. Under a frequently-cited figure showing the advantages of CDC, annuitisation accounts for more than half (22% of the 37%) of the gains of a CDC over a DC (this 22% goes towards profits for the firm that provides the annuity and other costs). However, post the 2014 Budget reforms, annuitisation can’t be taken as a given because individuals can use their pension pots as they will.
- There is an assumption that the charges will be lower in CDC than in DC schemes due to economies of scale – but this may not be the case. Again, the Government reduced this potential discrepancy significantly in March 2014 by capping fees at 0.75% for DC schemes. Notwithstanding this fact, there is still potentially a gain to savers assuming that the costs of a CDC settle lower than that of DC schemes.However, this gain only materialises if the benefits of scale are more compelling under CDC than under DC. It is not clear that this is the case. First, we should be very careful about importing assumptions about scale (and hence low administration costs) from the Netherlands. There, the scale is driven by ‘collective sector agreements’ that ensure the coverage of more than 95 percent of the employed population, and the government stipulates that coverage is compulsory in some sectors. Compulsion is not on the cards in the UK.Second, it is not clear why CDC is necessarily more likely to achieve economies of scale than DC schemes. For instance, a very high proportion of members opt into the default investment products of their DC scheme, thus offering significant potential for economies of scale in terms of investment strategy. As the DWP argued in its White Paper of 2013, ‘Scale can provide the potential for efficiencies in the costs of administration and investment management [in CDC]. However, these advantages apply equally to other forms of pension scheme’.
- There is an assumption that individuals have to crystalise their investments at a given moment – but they don’t. On this assumption there are two potential disadvantages of DC against CDC: first, individuals may have to realise their investments when the market is low (one of the problems felt in the wake of the financial crash); second, investments may be put onto low-yield / low-risk assets in the years leading up to retirement (thus sacrificing returns for security).However, this all rather assumes that individuals cannot smooth themselves. Once again, the 2014 Budget reform (partly at least) resolved this issue, giving individuals flexibility over drawing down their pensions pots. This freedom will enable individuals to continue with higher-risk investments for longer (thus remaining in higher-yield assets for longer). It also makes them less vulnerable to stock market volatility because individuals can delay realising the bulk of their investments if the market crashes. To give an example of someone who had their pension invested in the FTSE100. If they held onto the investment from October 2008 (when the market started to fall steeply) until April 2011 then the value of their investments would have returned to 85% of the original value. If they held on a few more years longer, then they would have returned to 100%.
- There is an assumption that everyone is the average – some types of people would be worse off under CDC. Better-off people typically enjoy far longer retirements than the less wealthy. CDC will favour those with higher life expectancy over those with lower life expectancy.As the SMF has previously argued, the state pension contains an injustice in that everyone gets the same state pension irrespective of the number of years they are expected to live in retirement. But people’s life expectancy varies significantly (with wealth a key factor): the post-65 life expectancy of a healthy male manual worker in the early 2000s was 14.1 years, while a similar professional could look forward to an 18.3 year retirement. In addition, individuals on a DC who are unhealthy at the point of retirement would be better to buy a specific annuity product that could price in their shorter life expectancy and give them a higher income per year.
Greater certainty of retirement income
Advocates’ second main claim is that CDC provides greater certainty of income, but this is only true by degree and can come at a high cost.
- The fluctuation in CDC may be more modest but retirement incomes are not guaranteed. The evidence suggests that retirement income fluctuates less under a CDC than a DC but that there is still significant volatility. When the liabilities of the scheme cannot be met by the existing funds, the scheme either has to mandate higher contributions from those of working age or cut the pay outs to the retired (or both). For instance, in the Netherlands (the pin-up boy of CDC), there was a shortfall in the fund of Euro 30bn in 2012. Average pensions were cut by 2%; some schemes cut them by 7%.
- CDC shares the risks across generations but in so doing risks intergenerational unfairness. CDC can only provide certainty of retirement income at the expense of requiring higher contributions from younger generations. In the UK during the economic downturn this may well have meant younger people not only bearing directly the burden of the fiscal consolidation and of low wages but also having to make larger contributions to maintain pension pay outs for the retired generation. In the Netherlands, because longevity was underestimated and investment returns overestimated, younger generations will face lower retirement incomes than they would otherwise have received had they not been sharing risks with older generations.In a voluntary system this may carry the additional risk of young people leaving (or failing to enter) the scheme if the costs of supporting the retired cohort grow too large. And that spells real disaster.
So are they all they’re cracked up to be?
So, there may be some gains to collective pensions over individual pensions – but these look far less clear cut in the wake of the Budget reforms. And, we shouldn’t forget the significant potential downsides. We might still be better ‘going Dutch’ (and each buy our own pension) rather than ‘going Dutch’ and follow the example of the Netherlands by moving to collective pensions.