Miracles and mirages of CDC

If you thought that British actuaries were emotionally flatlined, try mentioning the following three words: Collective Defined Contribution (CDC). The mere mention of these words will unleash a fierce and highly emotional debate, one that may never reach a satisfactory conclusion – given that that there are no clear definitions of what Collective DC actually is. The old joke about Keynes applies here; ask 6 actuaries what CDC is, and you will get 7 answers.

In principle, the general idea underpinning CDC is quite simple and can be illustrated by the Dutch transition from Defined Benefits to Defined Contribution. Of course, it turned out to be a quite complicated transition and it took the Dutch two decades of testing and debating CDC until they overhauled it in last years’ pension reform.

The Dutch Collective DC history

The Collective DC idea emerged in the Netherlands after the IT-bubble around the turn of the century. Up until then, Dutch pensions were Defined Benefit (DB) with inflation indexation. The schemes were managed in the traditional way, with one investment portfolio and an administration system based on accrued pension rights. Given the Netherlands’ history as a successful trading nation, it should not come as a surprise that they had included some well-chosen wordings in the fine print of DB contracts. This wording allowed for, under extreme conditions, retroactively changing the accrued pension rights.

From that point onwards, the financial risks were gradually transferred from employers to members. Currently, all financial risks are with members. Despite this dramatic change in the underlying pension contract, the operating model did not change. Dutch pension schemes continued to have one investment portfolio for all members and DB style pension rights administration. To protect the members, an insurance inspired regulatory regime was introduced, under which the pension contract was interpreted as a nominal ‘guarantee’ with conditional indexation. To avoid the chance that younger members could end up in a solvency trap, a safety valve was introduced by the regulator. In the event that scheme funding falls below the nominal ‘guarantee’, all pension rights must, after a recovery period, be reduced.

After two decades of debating the inter-generational transfers within the CDC, the Dutch passed a pension reform last year, through which they are taking the next natural step in the journey of collective pensions. This reform is evolutionary since it has retired the DB inspired accounting framework based on pension rights and introduces a DC accounting system based on units. Through this transition, all existing pension rights will be retroactively exchanged for units in the new accounting system. This makes is possible for a pension scheme to introduce a virtual ‘life cycle’ within the collective, enabling young and old members to have different risk profiles linked to the collective investment portfolio. To retain some collective elements, the trustees of a pension scheme can opt to have ‘unallocated reserves’, but these are capped at a maximum of 15% of the scheme assets.

The miracle and mirages of Collective DC

There are many claims around what CDC can deliver. Some claims have substance, while others are merely smoke and mirrors. To gain better insight into the fundamentals of this framework, it is necessary to deconstruct the different components of CDC, cherry picking the good parts and discarding the dysfunctional parts. For example, pooling of diversifiable risk may well be the eighth wonder of the world, while intergenerational risk sharing is just a mirage.

The miracle of pooling

Some risks can be reduced by pooling. From the insurance world, we know that it is much less risky to provide ￡80 million worth of life insurance for a pool of 500 individuals, than one life insurance of ￡80 million for a single individual. Other risks are not reduced by pooling, for example, one pound from one million people has exactly the same financial risk as one million pounds from one person. The same contributions, the same investment costs, the same investment returns will result in, hold your breath, the same financial outcomes. Ultimately there is no magic outcome achieved by pooling financial risks. That said, financial risks can be reduced by diversification in the investment portfolio, but that is a different story.

The alchemy of accounting

The creative accounting framework underpinning CDC belongs to the same school of accounting alchemy as Arthur Anderson and Enron applied in the late 90s. The idea is to base today’s pension payments on future expected investment returns. This means that we need ‘objective’ assumptions on longevity, future interest rates and stock market returns. Unfortunately, the track record of ‘objectively’ predicting longevity and interest rates has been extraordinary poor. In addition, when a CDC scheme comes under financial pressure, so does the ‘objectiveness’ of the assumptions. This requires strict regulation to mitigate the built-in agency issues of the CDC design. Perhaps, the acronym CDC should really stand for Complicated DC!

The mirage of intergenerational risk sharing

If you enjoy a robust philosophical debate with friends over a glass of wine, intergenerational risk sharing can provide a great sparring topic, simply because there are no clear winners. Any attempt to provide a coherent line of reasoning requires the introduction of several highly hypothetical assumptions. The problem is that even if our logic is impeccable, it is only valid if the assumptions hold. The two critical assumptions behind intergenerational risk sharing are that participation is mandatory and that the arrangement will continue perpetually. A quick reality check: the Dutch Complicated DC experiment with intergenerational risk sharing lasted roughly 20 years, which is a significantly shorter time-period than infinity...

The power of collective bargaining

The core advantage of CDC is its collective bargaining power. With a large asset pool, it is possible to build a diversified investment portfolio and negotiate a good deal with financial service providers in a way that retail consumers cannot. The lessons from Australia are clear, where Superannuation schemes operated by retail providers got slapped hard on the wrist by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry for charging excessive fees. The point is that we don’t need to move to a CDC solution to reap the benefits of collective bargaining power: in the UK, most of it is already structurally achievable via larger master trusts.

Lessons for the UK

We learn from our own mistakes, but it is much faster and cheaper to learn from other peoples’ mistakes. The Dutch journey is a priceless lesson for anyone interested in Complicated DC, since they researched every facet of CDC and, as a consequence, took important steps towards a more robust version of it. The conclusion? CDC is not the silver bullet that will solve the UK’s pension issues, but it does offer attractive components for draw-down solutions. Perhaps it is time for the legislator to explore the possibility for UK master trusts to develop pay-out alternatives that include pooling of individual longevity but without capital guarantees?

In a complex world of many unknowns, the only thing that I am certain of is that things will continue to change – necessitating pension solutions that are adaptive as the conditions changes. The current Dutch CDC was not suitably adaptive, and therefore is now being overhauled into something better, which probably will be revised in a few decades from now. My recommendation in the UK debate is to keep our system simple, flexible and adaptable to the rapid changes challenging and shaping society today and in the future.