There is nothing new under the sun

Reports surfaced last week that the UK Government would look again at so-called “Defined Ambition” pension provision.

The idea of “Defined Ambition” provision is to offer more predictable benefits than current defined contribution schemes can offer, but without the onerous costs and guarantees of traditional defined benefit schemes. At that level, the idea sounds potentially attractive: the missing “third way” of pension provision, balancing yin and yang, helping us all to the nirvana of a secure, affordable retirement.

Yet few of the ideas put forward under the “Defined Ambition” umbrella are really new. Some, in fact, are very old. Several have been abandoned, for one reason or another; their era past. “Defined Ambition” itself was looked at by the Coalition Government, but went nowhere: fizzling out, a damp squib. 

Ideas, like fashions, echo down the years. Some are welcome, some are not. Some fit a vital need, others are mere frivolities. Where in all this does Defined Ambition fit? 

The current focus of the Defined Ambition advocates is “Collective Defined Contribution”, or CDC – an idea seemingly borrowed from our Dutch neighbours. 

Of the original “Defined Ambition” ideas consulted on in 2013, CDC was the only one identified as potentially warranting further legislation in the June 2014 consultation response. 

Under the CDC approach, there may be a stated target benefit, but members and employers pay fixed contributions – it is, first and foremost a defined contribution scheme.

However, instead of each member having a separately identifiable pot of money that is “theirs”, all the pots are managed together. When you come to take “your” money out, the people running the CDC scheme would pay you what they think is fair, based on what you paid in, the returns achieved, and their need to be fair to everyone else as well.

What this means, in practice, is that if returns have been really good, you won’t get the full benefit of that return: the people running the CDC scheme will hold some money back to help protect people who might be drawing benefits at a time when returns have not been so good. Market bumps get smoothed out, with the idea that most people should get something reasonably close to what they were expecting.

It seems wonderfully egalitarian; pooling resources for the common good; very Dutch; very innovative. 

In fact, it’s very old. We’ve had schemes that work like this in the UK for many years. We just don’t call it “collective defined contribution” or “CDC”.

We call it “with-profits”.

“With-profits” funds date back centuries – Equitable Life became the first provider to distribute a reversionary bonus (one of the hallmarks of the with-profits fund) way back in 1781. As time went on, with-profits funds became hugely popular in the UK; they were used by DB and DC pension schemes; they were used for savings and endowment policies. Early this century, though, with-profits funds fell out of favour.

At a surface level, “with-profits” policies and CDC schemes might look different, but at a brass-tacks level they are doing the same basic thing. Each depends on the principle of smoothing out market returns – holding money back in “good” years to help pay for “bad” years. Unlike some of the other “risk-sharing” ideas out there, CDC schemes don’t share risks between employers and members: all of the risks are shared out amongst the members.

The decision on what to pay out is an actuary’s tight-rope walk. You have to balance a known past with an unknown future. 

If you are too cautious about the future, if you hold back too much for leaner times then the people who retire today will be disappointed.

If your view of the future is too rosy then you might pay out too much today. People retiring today might be very happy, but you might not have enough in reserve to protect members if things don’t go the way you hoped.

Everything would be easy if we knew what the future held, but no-one does.

Through the late 20th century, with-profits funds did well, buoyed by the optimism of the time. Providers invested heavily in equity markets, which seemed to rise year after year. Because returns on with-profits funds were “smoothed”, they were seen as lower risk than equity-based unit-linked funds, even if they held the same underlying investments. Competitive pressure incentivised providers to target high returns, to maintain high payouts to policy holders, to sell that expectation to prospective investors. Equitable Life – and others – offered guarantees to entice investors.

The success of with-profits funds carried within it the seed of their downfall. As the new century dawned, markets turned. The tech bubble burst. Accounting scandals broke at Enron and Worldcom. As equity markets fell, it became harder and harder for the with-profits funds to maintain payouts.

Equitable Life itself closed to business in 2000. Its history of generous payouts – which had been so popular in the fat years – meant it didn’t have enough money to cover the guarantees it had given its members. Others fared better, but still needed to trim the payouts they made. As markets fell, providers had to reduce the amounts they paid to members who took their benefits out early. Unsurprisingly, members were not happy.

With-profits funds still exist; however, their popularity has faded. Investors these days value simplicity and transparency; with-profits funds offer neither. Tighter regulation means with-profits funds are likely to hold lower-risk investments than was the case a quarter century ago – while that change helps to make returns more predictable, it also means returns are likely to be lower than in the heady days of the last century. For many, the name is forever tarnished by the fate of Equitable Life.

Ideas, like fashions, echo down the years – returning time and again, sometimes in altered form. 

In some respects, the CDC ideas being discussed now go further than the old “with-profits” idea: in these CDC schemes, even members who have started to draw their benefits could see their payouts cut. Telling a pensioner you have to cut their retirement income helps the mathematics of risk-sharing, but is hardly palatable in the real world. Even in the Netherlands, the home of CDC, cutting benefits does not go down well. Reputational risks for providers and sponsors of CDC schemes could be high, particularly since the complexity of the idea makes it unlikely members will truly understand how (and why) their benefits may be reduced.

With-profits funds were popular for two centuries. Perhaps CDC, as a reincarnation of that old idea, can be successful too; however, for CDC to flourish and to stand any chance of providing members with a reasonable income in retirement, its advocates need to prove that they have learnt the lessons of with-profits. Its advocates also need to show that there is demand from employers, in this day and age, for a product like CDC.

It is far from clear that such a demand exists.

The truth is that there is no shortage of ideas and products that already bridge the gulf between old-style final salary schemes and defined contribution schemes, often in much simpler ways than CDC. 

Normal DC schemes can invest in with-profits funds if they want to – offering a “collective” approach akin to CDC. Capital protected DC investment options exist, though they are rarely used because of the cost involved in capital protection. 

The tide of legislation on DB benefits has also turned: the requirements on pension increases have been reduced; since 2016 DB schemes have no longer had to provide dependants’ benefits on new pensions; the headline benefit requirements under the current auto-enrolment regime are nowhere near as onerous as the requirements we had 20 years ago. The freedom & choice agenda has meant that – rightly or wrongly – many benefits in DB schemes are now being converted to DC (one of the other ideas discussed under the “Defined Ambition” banner).

Employers have also developed ways to share pension risks with (rather than amongst) employees. Some employers share costs explicitly with members, though these structures can prove difficult given the steep rise in pension costs. Others provide a low “core” DB pension, with DC on top. Others have used ideas such as “longevity adjustment factors” to adjust benefits to stabilise costs.

Cash balance schemes remain niche in the UK, but have attractions, particularly in a world of "freedom & choice". These schemes are designed around a lump sum (rather than a pension) at retirement. The employer bears the risk around investment returns up to the point of retirement; at retirement the member bears the risk around what income can be secured with their lump sum.

Despite all these ideas, the predominant trend remains for employers to close their DB schemes and move to DC. In this crowded field, could CDC offer a better way? Perhaps. For now, though, I remain a sceptic.