Is there a third way for private sector pensions?

Is there a third way for private sector pensions?

Stack of pension coins declining in size

Prospect’s pension policy can largely be summarised as fighting to defend defined benefit (DB) pensions for members who have them and campaigning to improve the quality of the defined contribution (DC) pension schemes that are generally available to other members.

DB pension schemes in the public sector have been radically reformed but they are still good quality schemes, remain open to new entrants and are sustainable.

However, there has been a significant decline in private sector DB schemes. Estimates from ONS show that private sector membership fell from 2.6 million in 2008 to 1.1 million in 2017; only 500,000 private sector workers had access to an open DB pension scheme in 2017. On these trends, DB schemes will eventually only exist in small pockets outside the public sector.

It’s not good enough to just bemoan the factors driving the decline of private sector DB provision; we need to address the consequences for members.

How can we improve pensions in the private sector?

An obvious priority is to campaign for higher employer contributions to DC pension schemes.

For millions of DC members the focus must be on increasing the desultory minimum employer contribution levels required under automatic enrolment.

Thankfully, for most Prospect members of DC schemes, it’s about negotiating improvements to levels of employer contributions that are generally already upper quartile (but need to be even higher to give members a good chance of being able to retire at a reasonable age with a decent standard of living). We have had many successes and continue to campaign on this wherever we represent members.  

Another option is to campaign for a better alternative to DC pension schemes. In 2018, Prospect’s national conference supported a motion that called on the union to engage with employers who only offer DC schemes on alternative designs that could offer better outcomes.

What alternative pension scheme designs might be possible?

A number of pension scheme designs fall somewhere in the range between the extremes of DB (where the sponsoring employer bears nearly all the risk) and DC (where the pension scheme member bears all the risk). Unfortunately, the level of take-up has not been very high so far.

Currently there is a lot of attention on Collective Defined Contribution (CDC) pension schemes. There are reasons why CDC schemes could potentially enjoy take-up levels that have largely eluded other alternative pension scheme designs.

  • Potentially attractive to employers

From an employer’s point of view, the only commitment with a CDC pension scheme is to pay the set level of contributions. By design, a CDC scheme cannot have a deficit and so the employer is not running risks associated with investment returns, inflation or longevity that it does under a DB scheme.

Recently the Royal Mail reached an agreement with the CWU to introduce a CDC pension scheme for its workforce.

  • Trade unions are open-minded

As well as the support of CWU members for the proposed CDC pension scheme in the Royal Mail, the concept of CDC schemes is attracting positive attention from trade unions.

In 2018, TUC Congress passed a motion that “supports the introduction of CDC as an alternative to DC”. The Prospect national conference motion mentioned above called for engagement “with employers which only offer DC pension arrangements to develop ‘hybrid’ pension schemes”.

  • Government is supportive

Last year the Work and Pensions select committee issued a report that supported CDC pension schemes. The summary said:

“CDC may well appeal to companies who want to offer good pensions to their staff without the risk of large long-term pension liabilities on their balance sheets. The prospect of a regular and relatively reliable income in retirement may be welcomed by those staff. Through the pooling of risk between scheme members, CDC may well also provide more generous pensions on average than standard DC saving. CDC would therefore be a good choice for some employers and some savers.”

In response to that report the government started a consultation on CDC pension schemes in November 2018. The consultation made it clear that the government intended to introduce new legislation to provide a statutory framework for the Royal Mail CDC pension scheme, and potentially others, to go ahead. Preparation of the Bill is advanced and the minister hopes it will it be published in 2019.

What is a CDC pension scheme?

While there are a large number of possible variations in design, there are some core features of CDC schemes:

  • The contributions payable by members and the employer are set in advance (in this sense they are the same as traditional DC schemes from an employer’s point of view).
  • Instead of individual pension pots (as with traditional DC schemes), the contributions are paid into a collective fund which is managed on behalf of all members.
  • The accumulated funds aims to pay scheme members a target level of pension when they retire. For example, each year a member might build up a target pension of 1/80th of pay, payable from age 67. The target pension would increase each year (perhaps in line with CPI) both before and after retirement.
  • The crucial difference from a DB scheme offering equivalent levels of pension benefits is that the target level of pension is not guaranteed in a CDC scheme.
  • At regular intervals an actuarial valuation is carried out to ensure that the assets and liabilities of the scheme are in balance. This can therefore result in target benefits (already earned and to be earned in future) being increased or decreased to keep the scheme in balance.

To be absolutely clear – CDC pension schemes may appear like DB schemes from a member’s point of view and operate like them in certain ways but, from a risk point of view, they are similar to DC schemes because members bear the risks. However, in a CDC scheme the members share the risks collectively rather than bear them individually as in DC schemes.   

Why might CDC pension schemes be attractive to Prospect members?

Modelling by a number of respected organisations suggests that CDC pension schemes can produce higher and less volatile outcomes than DC schemes. This modelling is based on assumptions and/or historical data and is not universally accepted but there are reasons why we might expect CDC schemes to outperform DC schemes:

  • A member of a CDC pension scheme can benefit from a longer period of investment in equities, and therefore potentially higher returns, compared to a member of a DC scheme who purchases an annuity at retirement.
  • If a member of a DC scheme chooses to benefit from a longer period of investment in equities through a drawdown product, they are exposed to significant longevity risk. This is due to not knowing how much income can be sustainably drawn down from the pension pot and also due to an individual's investment time horizon being limited. In a CDC scheme this risk is pooled across members.

Another key advantage of CDC pension schemes is:

  • Scheme members do not have to make major decisions. They do not have to choose between having to become pension experts (or engaging professional advisors) or being exposed to the risk of making poor choices at retirement that could have a very detrimental impact on their income.

Other potential advantages include:

  • CDC pension schemes can potentially invest in categories of asset classes that are not generally available to DC scheme members and this might offer greater diversification or hedging opportunities (such as the opportunity to earn a higher return by investing in illiquid investments, reflecting the longer investment time horizons in CDC schemes).
  • There can be savings on transaction costs because new contributions reduce the need to divest other assets to pay pensions.

Are there potential drawbacks to CDC pension schemes?

It would be wrong to ignore the criticism of CDC pension schemes by think tanks, pension experts and the press (£).

To deal with the main criticisms:

  • CDC pension schemes discriminate against younger members

It is an actuarial fact of life that the promise of a certain level of pension is more valuable to someone who is close to receiving it (ie an older person) than someone who wont get it for many years (ie a younger person). This is true whether that promise is guaranteed (as in a DB scheme) or is just an aspiration (as in a CDC scheme). So a CDC pension scheme that targets a similar benefit to a DB scheme will be more valuable to older members than younger members. This does not stop DB schemes being an extremely popular type of pension scheme design; possibly because younger scheme members all hope to eventually become older scheme members in time! It is not inherently unfair to promise the same expected level of pension to people regardless of age (indeed age discrimination regulations explicitly allow different types of pension schemes to do just that). It is possible to design a CDC pension scheme that delivers different levels of pension by age, but that would potentially make things overly complicated. CDC pension schemes must have stringent minimum standards so that they provide valuable benefits to members of all ages and the benefit structure must be clearly explained to members.

  • CDC pension scheme members don’t have a call on the scheme assets/cannot take advantage of pension freedoms/need future generations of members to pay their pensions

These criticisms are related and are based on a misconception of how CDC pension schemes would operate. It is absolutely possible for a CDC pension scheme to operate in a way that allows members to take a transfer of their share of the assets out of the scheme (whether to take advantage of pension freedoms or otherwise). If there were no new entrants, then over time the scheme’s trustees might look to merge with another scheme or adjust the investment policy to reflect the changing profile of members and continue to pay their pensions.

  • CDC pension schemes are with-profits schemes revisited

This criticism is obviously based on the view that with-profits schemes were a failure (they certainly have detractors and are much less popular now than they used to be). A major criticism of with-profits policies was their lack of transparency and the fact that the smoothing mechanism caused cross subsidies between different generations of policyholders. By contrast, CDC schemes can be transparent and there is no requirement for reserves to be built up so the risk of unfairness across the membership, particularly inter-generational unfairness, can be avoided.

  • CDC pension schemes could result in cuts to pensions in payment

It is a feature, and not a bug, of CDC pension scheme design that the amount of target pension, whether it is in payment or not, is not guaranteed. It is crucial that this is clearly communicated to potential members. Recent experiences in the Netherlands are often cited as proof of unacceptable outcomes as retired members faced cuts to their pensions but these need to be put in context. It is possible to minimise the risk of cuts to pensions in payment by including an inflation link to the target pension. This inflation link is then first to bear the brunt of any adverse experience requiring the target benefits to be reduced. The risk of an actual reduction to a pension in payment is therefore greatly reduced (but is not zero).

What should Prospect be doing?

As a democratic organisation, Prospect does what members want! Last year’s conference instructed Prospect to engage employers about different types of pension schemes. We held an event about CDC pension schemes for employers in the energy supply industry earlier this year. What, if anything, we do next is up to you.

If any branches feel that CDC pension scheme design might have attractions for their members, then your reps should get in touch with us and we can explore this further.

It is unlikely that employers are going to spontaneously offer to “upgrade” their DC schemes to CDC pension schemes. If we want members to avail of the potential advantages of these schemes, we are going to have to take the initiative by putting them on employers’ agendas ourselves.

Neil Walsh

Neil Walsh


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