How do we ensure fairness in CDC schemes?
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Why fairness matters in CDC pension schemes
CDC schemes provide an income for life, at a level that is widely expected to be significantly higher than available from a DC scheme for a comparable spend.
As a result, CDC is expected to be very attractive to the significant cohorts of people who value an income for life in retirement with no complicated decisions to make on investments or when to take benefits and how much. This was covered in our Future of Pensions report.
However, any new pension arrangement needs to earn the trust of members and their employers. Some commentators have questioned the fairness of CDC schemes. This is an important consideration. We believe well-designed CDC schemes are both fair and maintain the other benefits of CDC.
In this blog, we discuss the issue of fairness in CDC and explain how the next generation of CDC schemes are being designed to ensure fairness.
What fairness means in CDC context?
Fairness means different things to different people.
A DC scheme is fair in the sense that a member has control over where their pension is invested and how to use their pot at retirement. The income a member receives in retirement is determined by the decisions they make, and there is no cross-subsidy between the DC pots of different members.
However, in practice only a small minority of savers make active decisions on how to invest their pot, with around 90% of DC members choosing the default investment option.
The highly individual nature of DC can lead to unfairness in a broader sense. Outcomes depend heavily on investment performance and economic conditions during key periods, such as the run up to retirement (when a pot will be at its largest), and if choosing drawdown, during the early years of retirement. These are largely outside members’ control.
This means that different generations of savers can experience different incomes in retirement, even if they made identical decisions. The risk sharing mechanism in CDC manages this to a greater extent.
By sharing risks between members, CDC schemes aim to provide more equitable outcomes over time.
Q&A
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Some CDC schemes in the Netherlands did not initially reflect worsening funding levels, for example after the 2008 financial crisis, in the pensions paid. This acted to favour older members over younger members when benefits were eventually adjusted. This will not be permitted under the UK CDC legislation: all experience, positive and negative, must be recognised promptly.
Multi-employer CDC schemes in the UK will also be required to pass an “actuarial equivalence” test. At high level, this means that the pension provided must be equal in value to the contributions paid and is an important extra measure to ensure fairness in UK CDC schemes.
One implication is that younger members will accrue more pension per pound of contribution made as their contributions can be invested for longer and generate more returns before being taken as pension.
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The organisations we are speaking to are carefully considering how to allow for differences in longevity expectations to make their schemes fair. So far, the most common method being explored is to adjust the accrual rate based on factors that have a proven correlation with life expectancy. For example, accrual rates could vary by job type (e.g. higher rate of accrual for manual workers), salary (higher rate of accrual for the lower paid) or location (higher rate of accrual for those who live in areas with lower life expectancy). In all cases, the goal is that members with lower life expectancies receive a higher initial rate of pension per pound of contribution, to ensure fairness with other members.
In making these adjustments, it is important to balance theoretical fairness against the complexity of both running the scheme and explaining how it works.
Longevity pooling is an important feature of CDC that allows members to have the security of an income for life. We believe that the proposed approaches, which include an element of risk pooling while adjusting for known differences in life expectancy, represent a fair compromise.
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CDC schemes will be required to use best estimate assumptions. For example, there should be a 50/50 chance that future investment returns will be more or less favourable than assumed. This means it is equally likely that pension increases go up or go down in future – and if they go up, then younger members will benefit more than older members.
Secondly, members’ priorities for their pension are likely to change over time, and CDC reflects this well. For a younger member, the key is maximising value in the long-term. Short-term volatility is not necessarily a bad thing if it results in a higher long-term return. On the other hand, for members close to retirement, predictability of retirement income is typically the main focus. In a CDC scheme, a member within five years of retirement will have a good idea of the pension they will receive.
Nevertheless, we are seeing innovative approaches being considered for CDC, including whether to compensate for the greater variation in potential outcomes for younger members in the accrual rates.
Conclusion
Risk transfer is inherent in CDC, but is there to achieve desirable aims for members: higher pensions, an income for life, and no complex decision-making. Structuring benefits carefully to avoid known areas of risk transfer, whether inter-generationally or between different demographic groups, is key to maximising fairness, whilst achieving the broader benefits offered by CDC.
We are optimistic that the coming wave of CDC schemes will achieve this and earn the trust of their future members and their employers.
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