David Pitt-Watson: I am David Pitt-Watson. For the last six years, I have been leading a study for the Royal Society of Arts, a venerable non-party-political think tank investigating how we could deliver a better pension system in Britain, with “better” defined by a series of citizen juries that we conducted five or six years ago. That is my background on this. I am a former fund manager for the largest pension fund in Britain, and I currently teach in the finance faculty at London Business School.
Stefan Lundbergh: I am Stefan Lundbergh. I work at Cardano. I have been quite involved in the Dutch reforms of the collective defined-contribution schemes. I am Swedish, and I am also a board member of one of the Swedish AP funds. I am interested in pension design and how to provide a good pension for the end consumer, and I have experience in the UK, Sweden and Holland.
Derek Benstead: I am Derek Benstead of First Actuarial. I am an actuary responsible for running defined-benefit pension schemes, in the main. I have a long-standing personal interest in innovative and effective pension scheme design. In particular, in the stakeholder pension consultation of 1998-99, I recommended a collective defined contribution.
May I ask our witnesses first to give the views of the organisations that they represent on the advantages and/or disadvantages of moving to collective defined-contribution pensions?
David Pitt-Watson: All the evidence we can find in all the studies that have been done, of which there are a number now, suggests that they give considerably higher pensions and are much more predictable. That is because pensions can be thought of as savings—part is savings—but the pension itself is an insurance. The best way to insure is to insure collectively, and in this case to insure for how many years you will live. In a collective defined arrangement, people can share that risk among themselves. That means that they do not need to go into the market and buy an annuity, which, as we all understand, is extremely expensive. There are a number of other advantages in terms of the timing of when you take the money out and the way you invest, but when you put all those together, most of the studies suggest that there is maybe a 30% or 40% upside from investing collectively rather than investing individually and that a more predictable pension comes out of it. This is really quite a substantial step forward.
Stefan Lundbergh: I think I disagree a bit with you, David. My experience comes from Holland where we had a large debate on how you make a good collective DC. One thing we discovered is that if you compare apple with apple, there is not such a big difference in the outcome of pension. You have to invest in the financial markets. You have to think about it. If you construct it in a good way and you have an equally designed individual DC, you can show it is very close to a collective scheme. That said, there is a big advantage to a collective scheme, which is in how you frame retirement. It is a retirement income. There I agree with David. It is really important that you look at the cash flow in relation to an annuity.
The advantage with collective schemes is in the implementation. Compared with a market solution, you can focus on the right goal—a stable retirement income—and you avoid some of the things where the market does not work so well. Competition does not always give a better product in the financial sector. You can also better manage the agency risk. So, from a purely financial perspective, in an ideal world you can make them quite similar, but when you implement it, that is where the advantages kick in because you have someone like a trustee who looks after the members’ best interest. That is why I would recommend a collective scheme.
Derek Benstead: I would affirm David’s points, which in effect affirmed the merits of a collective defined-contribution scheme, relative to individual money purchase. I would agree that a collective defined-contribution scheme should produce a much more stable benefit outcome than the very unstable outcomes of individual money purchase. It avoids the cliff edge of annuity purchase, which comes with individual money purchase. It allows greater flexibility of investment into retirement. Given the background of the freedom and choice aspects of the latest Budget and the relaxation of requirements to buy an annuity for the money purchase scheme, we need alternative ways to annuities to provide an income in retirement—not just drawing on capital savings, but income where there is a protection against longevity incorporated in the product. So a collective defined-contribution scheme can provide a new way for pensioners to obtain income that is not annuity purchase.
Hilary Salt: Very quickly, because most of the advantages have been said, there are two advantages that I would mention. First, with the collective way of providing income in retirement it is possible for a scheme to have a longer period in higher-yielding investments rather than having to switch to very low volatility bond-type investments in retirement. Secondly, it is a way in which people can pool longevity risk, and pooling risk is an important element of what CDC brings.
Perhaps I should say a couple of things on the disadvantages, because people have not mentioned those and that was part of the question. A couple of disadvantages are really overplayed. One disadvantage that is often raised is the idea that they can introduce a lot of intergenerational inequality. I would absolutely refute that. There are ways that CDC can be set up that involve intergenerational inequality, but it is not a necessary part of setting up CDC. Perhaps in the time that we have, we can develop further how to build a CDC scheme that does not have intergenerational inequality built into it.
The other point on disadvantages is that trying to set up a CDC scheme with a group of members who trust no one will not work. It has to be built on a framework of trust. Members have to trust the managers of the scheme. That can be built by having a clear understanding of what the scheme does, a lot of transparency and a lot of legislative requirements—not on what the scheme and the scheme managers do, but on what they must not do. For example, they must treat people equitably across the piece. So, some of the disadvantages that people often put forward can be managed.
David Fairs: I will not repeat the advantages that have already been said, but to add to that, at the moment we live in a world that is very black and white. You are either in defined benefit or defined contribution. Many employers are finding the costs and the volatility of costs associated with defined-benefit schemes too much for them to bear as an organisation. They are almost left with no alternative but to go to defined contribution. What CDC does is introduce various shades of grey so that an employer can decide to take on some of the risk, but not the entire risk that they would have to under defined-benefit schemes. Some large employers feel very frustrated that they have looked after employees in a defined-contribution scheme to the point that they got to retirement and then employees—at the moment—are forced to buy an annuity, although there are other freedoms. However, employees want a degree of certainty of retirement income when they retire, and collective DC schemes create the infrastructure that will enable employers to provide that guarantee at a level of risk that they find acceptable.
Hilary Salt: Okay. If you built a CDC scheme that looked very much like today’s defined-benefit-type arrangements, it would have a target level of benefits. If you were going to offer a target level of benefits and said to people that there was a very high chance that those benefits would be paid, you would need to build up a reserve in that scheme. Building up a reserve in that scheme would mean that the first generation of members of that scheme would not get value for money, because perhaps £3 in £10 of theirs would be kept within the scheme to build up that reserve, so as to be able to promise a higher benefits.
That is kind of the position we are in these days with defined-benefit schemes, where you have such a high level of certainty that benefits will be paid that employers are forced into a position where they can provide only a very low level of benefits. We want to avoid that same mistake with CDC. So, to build a CDC scheme that did not have that intergenerational inequality, you would build it in a way that aimed to provide a target level of benefits and it was 50% likely that that benefit would be met, and 50% likely that it would not. Or 50% likely you would get more and 50% likely you would get less is perhaps a better way to explain it to members.
That means that you would not have to build up a reserve, so the money that the first generation of savers put in would come out to that first generation of savers, rather than being kept within the scheme to provide a buffer so as to be able to promise benefits to a future generation.
That is the real first principle of basing the level of benefits that you expect to pay on a best estimate of what you can afford. That does not mean that that is always the way that you will communicate those benefits to members. You might build in a lot of caveats in the way that you communicate those benefits to members, but the basis on which you fund the scheme is on a best estimate basis. That is one of the reasons we welcome some of the changes that were made yesterday to the Bill around establishing ranges of probabilities, rather than a set target that you have to be better than.
Stefan Lundbergh: I can add to that that in Holland the big debate was that you need to have transparent ownership rights. That was not the case in the past and that is why there was a big debate in Holland that the system is not sustainable. It has to be clear who owns what at all times and it is good if you have clear rules about what is going to happen, how you are going to redistribute things if something happens. You have what we call, in technical terms, a complete contract; there is no room for wiggling or reallocating things, so it is fair to everyone and every cohort or group in the collective should be treated such that there are no winner or loser cohorts. That is very important for trust.
I have a quick question for each member of the panel, starting with David. You said that outcome is 30% to 40% better for collective DC than for normal DC. How do you know what the outcomes from my DC are? You can mull that over.
Stefan, if the Dutch experience has not been entirely satisfactory, where has the experience been better and what can we learn from that?
Derek, you talked about the cliff edge of annuities. That cliff edge, surely, has gone?
Hilary, you mentioned the advantage of a longer period of higher-interest investments. I do not see why that should be the case. As an individual, I can decide exactly what my investment is going to.
David, it is 50 shades of grey. I see the argument for why a defined-benefit scheme would want to change into a collective DC, but surely that is just a watering down of what already exists, rather than a strengthening of what does not yet exist?
Stefan Lundbergh: I would say that the best way to learn is to look at other people’s mistakes. The Dutch made a couple of mistakes in their design process in the past that they are now trying to correct. You have the luxury of starting with a blank sheet so you can make it right from the beginning. The best exercise is to study those who tried to do something like what you are trying to do and messed up on the way, because that is the most valuable piece. In Denmark, they have, in the Arbejdsmarkedets Tillægspension—ATP—solution, which is part of the public system, a decent model whereby they offer guarantees and they run it very strictly from a risk-management perspective. It is a good role model, but that is also run like a Crown company, or something at arm’s length from the Government. That could be a nice study.
Derek Benstead: Compulsory annuity purchase is outgoing, but the cliff edge of converting an account of money into an income that provides longevity of protection has not gone. The current position is that a person with a money purchase account can either buy an annuity or take a cash sum with no longevity protection. It is a little too polarised to say that, but that is basically it. A CDC scheme would offer a new way of obtaining an income that avoids the cliff edge of converting a pot of money into a lifetime income based on market conditions on the day that transaction is executed.
Hilary Salt: This is largely the same point, because you may be right when you say that freedom and choice in pensions will mean that you can take your pot and leave it in equities for a long time post-retirement. That might be true for some people. For a lot of people on low and median earnings, that is really not an issue, partly because the kind of products that they will have that would allow them to do that will be expensive compared with the level of the pot they have if they are doing it on an individual basis, rather than on a collective basis, and partly just because they are much less able to stand the risks of high-risk equity investment in the long term.
The other point concerns longevity. If you are doing things individually and not collectively, you are not sharing that mortality risk—longevity risk is a better phrase. People understand mortality risk very easily. For example, if you are a 30-year-old, you might think you need £500,000 to look after your family if you die. If you as a 30-year-old try to save £500,000, you are not going to do it. If 1,000 of you save £500, that is easy to do, and you can see that that pooling of risk in a death situation is fairly easy to grasp. It is exactly the same with an annuity. If you are the one in 1,000 people who lives to 110, you will have enough if you are in a collective arrangement in a CDC post-retirement scenario, whereas if you are an individual, unless you save enough in your little pot to live on to 110, you will run out of money.
David Fairs: In terms of whether it is watering down, we have seen a significant number of defined-benefit schemes that have already closed. In the run-up to 2016 and the abolition of contracting out, a lot of employers are reviewing their retirement provision, and I think we will see significantly more defined-benefit schemes close around 2016. You could say this is a watering down, but there is a tendency towards closing down defined-benefit schemes anyway.
There is the additional point that defined-benefit schemes in many ways are designed on an employment and social model that existed in the 1950s. There are far more women in the working population and far fewer men; far more part-time people; people now live twice as long; and people are much more likely to get divorced. So on the pensions structure that exists under defined-benefit schemes, I think employers are saying, “That just does not fit the work force that I have at the moment. I want a vehicle that I can flex to better adapt to that requirement.”
One of the criticisms is that nobody is interested: “DB is going; everybody just goes to individual DC. This is all an awful lot of time and effort for nothing at all.” I will start with David and David, but any of the other colleagues can come in. What is your sense of employer appetite? Is this all just a theoretical nicety that nobody is interested in?
David Fairs: No, I have a client who is working on the assumption that the legislation will work its way through. It is quite challenging for employers who have defined-benefit provision or have a unionised agreement to say publicly, “If you pass this piece of legislation, I will move into it”, because that is breaking the agreement with the unions and breaking the trust that they have got with employees, so I think employers want to go through a proper process of consultation. But, privately, lots of employers are thinking about how they can use this legislation to provide benefits for employees. So I suspect that, mostly in the larger employers initially, we will see something launched and then I think that trickle will start to increase.
Hilary Salt: It does not have to be employer-led. With CDC, all you need from an employer is a contribution, so CDC schemes could exist without any employer sponsorship, at it were, or participation. They could be led by beneficiary organisations or other organisations without the need for a sponsoring employer.
Stefan Lundbergh: The biggest challenge to get it going is that, if you are just going to get contributions, it will take for ever until you build a big enough pool to run it. So what you need is a launching collective. You need a group that says, “We want to be part of it.” Finding something like the social partner—the unions or employers—to set this up would be the way it could work. You can also do it with public intervention—an add-on to NEST or something like that—but I think it will need some help to get it going. Once it gets going, it is really good, but the difficult part is getting it going. In both Holland and Sweden you have solutions such as this. We have a very strong tradition of high union membership, and this has been pushed from that side. If you have only the market solution, the market does not have a need to set this up, because you cannot earn money quick enough on it unless you have a large launching collective, so that is the critical part.
We have had our market tainted by the Equitable Life scandal and other things, where what people think of as a promise ends up not being one. People are then stuck in a pot, their money has gone and they have no way out. How do you regulate something like this so that you have a meaningful promise without being a binding one, with people thinking they can rely on them but perhaps they cannot? It looks like a minefield of confusion, doesn’t it?
Hilary Salt: I think that is the hardest part of this. It is important to get that right. I would say there are three elements to regulation. One is that it must require schemes to be transparent. What is their policy on target benefits? What are the charges? Who is responsible for what? Secondly, it must have a fiduciary basis. There has to be a trustee-like body that manages the scheme and has a fiduciary duty to members. Thirdly, and probably most difficult, you have to communicate with members in a way that tells them to forget about DB.
For people of my generation that is quite challenging because members start from a DB. As soon as you say, “This level of benefit”, they start to think that is guaranteed. However, I do think that is changing quickly out there. Derek mentioned that lots of people have been auto-enrolled into DC schemes, or money purchase schemes, and often very poor ones. They do not really have a concept of DB, so perhaps it is easier with those members to start from a communications angle that does not say that the benefits are guaranteed.
Both in the legislative framework and in scheme communications, it is really important to start from the position that it is better than DC, not that it is like DB.
David Fairs: I agree with that wholeheartedly. It is critical that the governance and disclosure requirements around these schemes are set out clearly in regulation, and that employees understand what is guaranteed and what is something that will be provided if the experience is good. I think the disclosure to employees is critical.
Stefan Lundbergh: One problem when you bring up Equitable Life is that, in my view, that was a failure in supervision and legislation around that type of product. The product itself was not bad but there was no supervision, so you could promise whatever and get away with it, and then it did not work out. The strength now with a lot of the risk-based regulation is that it is difficult to promise too much. The key is that you should under-promise and over-deliver to keep the psychology in place. If inside you have fair and transparent ownership rights, it is market to market and you have regulation making sure you cannot over-promise, you are on a good way to create a sustainable system that people will trust.
Derek Benstead: I would like to add to some of the comments already made. I think the collective defined-contributions scheme is by definition defined contribution: the promise is the money going in not the benefits coming out. It is essential that, once the money is in, it is spent on the members plus the expenses of running the scheme, but with no refunds back to an employer, for example.
Having got the money in the scheme, the main requirement by far is to ensure that the legislation surrounding non-discrimination is sufficiently robust. We already have anti-age discrimination legislation, which is pretty much the same as legislation against unfair intergenerational allocation of resources. We heard Stefan comment on the importance of treating all members alike, whether they are active members, pensioners or deferred members. There was an item in the Pension Schemes Bill about protecting the interests of deferred members. There should be absolutely no discrimination between cohorts of members.
My main positive message is if the legislation around non-discrimination is robust, the outcomes will be non-discriminatory. There may be different ways to design the target benefit or manage the investments or the actuarial policies, but if at heart what trustees are doing is non-discriminatory surely that is satisfactory.
Alluding back to the Equitable Life example, Equitable Life had different cohorts of policy holders, with different policies that conflicted with each other; so a CDC scheme just needs no division between members—all members, be they actives, deferreds or pensioners, are one class of member, deserving of equal and fair treatment by the scheme’s managers and trustees.
That sounds absolutely right, but it is easier to reduce a forecast for someone aged 40 than it is to reduce a pension in payment to someone aged 80, is not it? The logical outcome of what you just said is that if the stock market takes a dive, or if actuarial assumptions go one way, you have to start reducing pensions in payment. Is that an attractive prospect?
Derek Benstead: No, it is not an attractive prospect—reducing pensions in payment. You refer to stock markets taking a dive. I would refer to a CDC scheme as being an exercise in cash-flow planning. The issue is one of estimating asset income cash flows and contribution income cash flows, and the spend on the benefit outgoing. It is a matter of balancing cash flows, rather than being driven by market prices on any particular day or month, that are of no particular consequence if you are not settling a benefit in full on that particular day. Market prices matter if you are buying an annuity. They do not matter if you are paying a pension out of a trust fund as it falls due for the next 30 years.
David Pitt-Watson: The issues that you are raising are really good ones, and for these to work you need to have the communications and actuarial oversight right, and, I would argue as well, you need trustee governance or something similar to it to make them work—I think, also, not pretending that there is a perfect pension system out there. I was preparing for this over the weekend, and was looking at my own pension statement: 10 years ago and now. I have got 30% more in my pension fund, and my predicted pension, which I can take in two years’ time—60 is my normal retirement age—is down by 12%. So the variation as I have come up to possible retirement is a third. That is not an exact comparison with the reduction in pensions in payment, and you need the flexibility for reductions in pension payment to get the full value from a CDC, but the sort of differences that one is looking at as one is coming to prepare for retirement are very high within the individual DC compared with what they would be in collective DC. They are not gone in collective DC, though, and one needs to understand that.
How do you stop people leaving a scheme? Say that I have been in a collective scheme and I get to 60 and have a massive heart attack and decide that I am now not going to live to see 70, so I will get out of this collective scheme quite quickly and start spending the cash. Do not you have a real risk that you lose all the people with a short life expectancy and just keep the healthy ones?
Derek Benstead: You need to distinguish between looking at a collective defined-contribution scheme as an alternative to defined benefits, which is one way of looking at it, or looking it as an alternative to money purchase, which is a different way of looking at it. It sits in the middle and, depending how you define the target benefits and manage the scheme, it might look more like defined benefits if you are maintaining a target benefit for years at a time; or it might look more like money purchase if you change the terms for converting a contribution into a target benefit daily with the market movements, if you are running a scheme where any individual can come and go whenever they want.
If you think about money purchase for the moment—individual money purchase—then if you have got 1,000 money purchase accounts, some of those will be long-lived people and some will be short-lived people, and the short-lived person will go and take their money and spend it, or buy an underwritten annuity and get a higher pension; and the long-lived person, if they want an annuity, will be buying an expensive annuity with quite long longevity assumptions, ending up with a lower income. That is all fine; that is how money purchase pensions work. What you receive out of the money purchase pension does depend on your individual circumstances. You are judging value for money in contribution terms. What you put in and earned is what comes out for you, as opposed to making that judgment in defined benefit terms, where everybody gets the same benefit package or, in a CDC scheme, nearly the same as you can manage for years at a time.
If you are running a CDC scheme, viewing it as an alternative to a money purchase scheme, and a number of members in ill health in the CDC scheme transfer out because they can do better for their family with the money if they leave the scheme, that is fine. That is what they would do in a money purchase context. If the people who are left are long-lived and the actuary running the CDC scheme consequently needs to assume that they are longer-lived and pay a smaller rate of a pension for a longer period of time, that is fine. That is just managing a collective group of longer-lived people and paying them a fair pension for their expected life span. To answer your question, if you look at a CDC as an alternative to money purchase, the principle that some shorter-lived people might transfer out leaving longer-lived people behind is fine. That is how it would be in the individual money purchase scenario.
It seems like, for collective to work, you have to have some winners and some losers; otherwise, presumably you have no winners or losers, in which case you are back to where you started. Does it seem that the only way that you get winners is if you have ignorant losers who choose not to leave at the time they ought to leave, for example? Are we not in danger of mis-selling to a load of people in that situation?
Stefan Lundbergh: I would say that if pensions are cut, that does not create losers because if the funding is not there and you do not cut pensions, you create losers. The losers are those who have to fill the gap. In Holland, we waited too long to cut pensions, hoping that things would go back to normal. Then, eventually, we had to cut them and it was a big shock to people. You start saying that your pension is no longer rock solid but that we will try to make it stable. It can be cut; it should be cut because that is how you create fairness between young and old.
Another problem is when you want to stick things in the collective scheme that do not belong there. Then you get into problems. Longevity is a good example. In this room, on average, we are going to live until 85 or something like that, if you believe actuarial tables. That means that some of us are going to live longer and some shorter. Tomorrow, we could invent a cure for terminal diseases and, all of a sudden, we are going to live until 95. You cannot hedge that risk in a collective scheme because, together, we can pool risk. If people start living longer, pensions have to go down.
If you believe you can hedge that risk by being in a collective, you will create winners and losers. The core thing is to figure out what you are going to put in the collective scheme. What risk should you share and not share? The better you design it, the more stable and robust it is, and the less unfairness there is between different generations and cohorts. You have to make up your mind when you design a collective scheme. With the DB, everything is protected and that is why it becomes very expensive. You say, “What do they do collectively and what do they pass on to the individual?” That is the most critical decision you have to make in CDC.
David Fairs: I think it is also envisaged that some risk capital would be put up. If an employer put up a degree of risk capital to run one of these arrangements, and there was a run of bad luck and risk capital was run down, that employer might well choose to top up that risk capital to keep the scheme running for longer. It would not necessarily be a requirement for the employer to top up the risk capital, but he might just for the benefit of his employees. That is the sort of risk that, under a defined benefit scheme, absolutely becomes an obligation on the employer, which, in a collective DC, depends on the employer’s fortune—whether he is able and willing to fund that.
David Fairs: I will start. The critical point is that if you have two regulators overseeing pensions, it is important that they be consistent when they are meant to be. If there is consistency between the regulators when they are looking at different vehicles for the same provision, you do not need a single regulator. If that is not capable of being implemented, you probably do. Consistency is a requirement.
Stefan Lundbergh: I can comment, although given I work in Holland, I have no experience of the regulator, so this is purely hypothetical. It is very difficult when you have two jurisdictions looking after one problem. Look at the philosophy behind auto-enrolment and the budget proposition from the Treasury. From an outside perspective, that seems a bit schizophrenic. When you have multiple regulators, you run the risk of their looking differently at the same topic when there is a boundary between the two regulators.
Derek Benstead: My understanding of the boundary between FCA and the Pensions Regulator is that the FCA looks after particular retail products, where an individual is contracting with a provider, and the Pensions Regulator looks after institutional, collective pensions, particularly defined-benefit pensions. In terms of collective defined contribution schemes, I would be very keen that those schemes are not exclusively employer-sponsored schemes but ones that individuals can join—for example, those with auto-enrolment money purchase pots and the self-employed. CDCs should be accessible to everyone, whether they are in employment or not. That rather means that the CDC falls under both counts. It is something that an individual might contract with, which, under current arrangements, might be under the FCA’s view, or it might be an employer-sponsored collective arrangement, which, under the present arrangements, would be under the Pensions Regulator. It seems to me that one product needs one regulator.
May I just play devil’s advocate, and offer you an explanation of what is going on, which I would love your comments on? I am not saying that I necessarily believe this to be the case, but what we are really looking at here is a compromise, which is trying to avoid a collective leap of the remaining DB schemes straight into money purchase. Within that messy compromise, the large remaining DB schemes will probably be able to function well as stand-alone collective DC, because they have the volume and bulk to buy in the expertise to make it work, but culturally, it is not hugely in the British DNA to shape our pensions structure in the way that they have been shaped in Holland, Denmark and, to some extent, in public schemes in Sweden. Actually, there is not any proof that the outcomes are any better, although there could certainly be proof that the costs should be considerably lower. In terms of the changing landscape of the annuities system, there really is not any particular reason to believe that longevity issues will be a major attraction of CDC. That is a sort of general sceptic’s approach. How would you all try to tackle that?
David Fairs: If you look at the income needs of people in retirement, it tends to be quite a high level of income, and quite stable, for maybe five to seven years, where somebody has an active retirement and their income needs are relatively high. As they approach late 70s and into their 80s, they actually get more sedentary, and income needs fall. Probably two years before they die, and nobody quite knows when that is, income needs quite often escalate quite markedly, and perhaps there is a need for funding of long-term care. If you asked an individual what sort of annuity they would like, it would be something that was stable for five to seven years, dropped down for a period of time, and then insured against long-term care at the end. Within the CDC framework, I think you will start to see providers come to the market with that type of product. The difference is that I think that product will be bought, not sold. People will voluntarily go out and look for those products, so they will have to look enticing to individuals.
On the other side, you have got employers who are concerned that their work force are not saving enough for retirement. There will come a point when an individual perhaps does not want to work and the employer does not want to keep them on the books, but the individual cannot afford to retire, so you get into this difficult position. There is a need to encourage employees to build up enough income so that they can have that type of retirement. Collectively, the changes that are on the books at the moment provide the infrastructure to allow you to create those schemes. From an individual perspective and an employer’s perspective, they are schemes that employees would want to be in and employers would want to provide, so I think there is a coming together of needs rather than a great British compromise.
Hilary Salt: On your first point—is this just a way to save DB?—I am afraid that that ship has sailed. The number of people in private sector DB schemes now is tiny. People talk a lot about the crisis in DB, but what they are not talking about is the crisis in DC. We have now got thousands, millions, of people—more are being added all the time—being auto-enrolled into DC schemes that will provide inadequate retirement incomes. I absolutely agree that people need income in retirement. Some of their needs will be volatile and will change over the period of their retirement, but they will all need a certain level of income for the vast majority of their retirement. That is the thing that we are trying to grapple with. We are trying to find a way of providing that efficiently, because annuities do so inefficiently. My desire to make CDC work is not a heart-wrenching liberal view; it is a really hard-hearted: “How do we find an efficient way as a society to provide income to people in retirement?” We have got to find it, because the DC schemes that we have at the moment just will not do it.
Are enough employers going to be able to fund the great difference between the current DC outcome for someone putting in x% of their income, and this outcome where they will have a significant amount of income guaranteed? Someone is going to have to pay for that.
Hilary Salt: I agree, but as those DB past service liabilities fade away long term, employers will find themselves in the situation where people come up to retirement and cannot afford to retire on their DC pot, and employers cannot force those people out of the workplace because of age discrimination. They will have to find a way of helping those people to leave, and that will be more pension provision.
May I ask the members of the panel a couple of questions briefly? The issue at hand is the comparison between individual defined contribution and collective defined contribution. The first question I want to ask is: what is the single greatest weakness of individual defined contribution that you believe or do not believe collective defined contribution can overcome? For example, from Stefan’s answer it seemed to me that the biggest advantage is changing the way we talk about retirement. For other members of the panel, it would be useful to have that on the record.
The second question is related. There are different models of collective defined contribution. Which model do you favour?
David Pitt-Watson: The weakness with individual saving is how you cope with longevity risk. Either you buy an annuity that will keep you going, but, as Richard said and as we discussed, they are really expensive and bring down what it is that you would otherwise have in your retirement, or else you do not know, as was discussed further on, whether you are going to live until you are 70 or 110, so you do not know how to smooth out your earnings. While we have individual DC, that is the weakness. Those weaknesses are mitigated greatly by collective DC.
Stefan Lundbergh: I can reiterate what I was saying earlier. The problem with individual DC is that people think of a pension pot or a set of pounds in a bucket for their retirement. If there is more money in the bucket today than yesterday, it has been a good day, but people need to buy a retirement income from that. Sometimes, just because your money goes up in value does not mean that you are going to be richer or can buy a better retirement income. It is a frame of mind. I either want a stable retirement income or a large pension pot. If you are looking at a pension pot, you get seduced because £100,000 is a lot of money, but it is not a lot of pension income.
How you frame the question is a really big issue. As David says, to hedge longevity in a group is great, because that has welfare improvements. That is why I am worried when I look at the UK from the outside. You greatly fix your build-out phase, but your pay-out phase is not done in a way that takes care of how people behave. I am more Homer Simpson than homo economicus. I am not fully rational when making decisions. The way that you ask the question will determine my answer. If I want to eat less, I would use a smaller plate. These are the things that make us human. We should create a pension system that adjusts to us as humans with all our behavioural biases, because they make us human instead of some perfectly rational, theoretical person that was thought up in an economics study in a book. That is what we have to do to the system.
The build-out phase is good here in the UK and you have made big steps forward. Why not have a think about that for the pay-out phase? If you do not, you will miss this thing that David talks about: pooling longevity. That is a big welfare increase. We are people. Even if I was not thinking about my pension, if someone comes up with a great default that I trust, I would be happy to go with it because I do not have to do so much fiddling with it myself.
Derek Benstead: In answer to your first question, the one feature of collective DC that I support, as opposed to individual money purchase, is the avoidance of annuity purchases. It is the one big thing that I think is the merit of CDC.
On the question of different models, I would compare and contrast the model of collective defined contribution as the alternative to a defined benefits scheme, under which you are doing something that looks a bit like defined benefits, but is not, as opposed to the other model of collective defined contribution as an alternative to money purchase. Taking the alternative to defined benefits first, under that model you would probably be looking to hold your target benefit package for a long time—a number of years at a time without variation. You might be putting in a contribution that is prudent—higher than the best estimate for the package of benefits being targeted—and you might be wanting a prudent funding policy. You would be looking at an even target benefit outcome over time as the basis of your communications with members and as your basis of judging intergenerational fairness—an even benefit package for everyone. There is probably an employer-sponsored context, particularly if you are prudently funding and putting in more money than is coming out in benefits. You are looking at accruing benefits every year that may not relate exactly to the contributions coming in, so that is an employer-sponsored kind of environment.
Looking at CDC as an alternative to money purchase schemes, it could be important to vary target benefits with market conditions from day to day. You are likely to be running a scheme that individuals can join, rather than employees, so people can opt in or opt out and transfer in or out whenever they want. It is important that that is on market terms.
Transfer values are likely to be very close to the sum total of assets in the scheme. The focus is on value for money and on the contribution going in being spent in an even-handed way, as opposed to the benefit coming out in an even-handed way. It is the focus on spending contributions fairly that is the fairness justification, so looking at an even spend per person rather than an even benefit per person. You are looking at a scheme that is universal for individuals who come and go, other than it being a condition of employment.
You are basically running a scheme where there is a pool of assets, where you are using actuarial valuation to divide the pool into an amount per person, rather than using an investment account to divide the pool into an amount per person. That is how I would compare it. Are you doing something like DB or like money purchase but smoother?
Hilary Salt: The only thing I would add is that I think it is important that the legislation is permissive, not restrictive. I would not like the legislation to require a model that required forecasting of stochastic probabilities of members having certain benefit outcomes. That kind of stochastic modelling of what might happen is just misleading to members and very expensive. I am not saying that a scheme should not do it but I would not want a model imposed by legislation that required that.
David Fairs: I think annuitisation is one of the big issues. People tend to look at where CDC operates around the world, in Holland and Sweden, and compare models. The UK is different in its social and employment patterns. I think it would be wrong just to import designs that work in a different country and social context and try to get them to work in the UK.
I suspect we will look back in 20 years’ time and say that we never thought that legislation would allow that sort of scheme, but that is the sort of scheme that fits the social norm and the employment pattern in the UK. My personal belief is that the first time you will see these is as an alternative to annuitisation at retirement. A lot of employees will want an income in retirement. At the moment they get to retirement, look at the annuity rates and find them singly unattractive. If an employer puts in a CDC arrangement as an alternative to an annuity, which looks better value for money, that becomes very attractive to the individual. It also becomes attractive to the employer because he can see that his employees, for the amount of money he has contributed to their pension pots, are getting a better outcome.
I think the first designs we will see will be like that. Then I think we will start to ask, when people have built up in their 40s a reasonable amount of income, is there a guarantee around investment return that we can provide? My view is that that is the way it will develop. I suspect we will end up with a design that none of us envisaged when we pass the legislation.
David Pitt-Watson: I think there are good trustees. The one thing you might want to think about is how to generate a system that has not got hundreds and hundreds of CDC schemes, but has a few. That has advantages because you can get low cost and all the rest of it. If you have a few you probably have even more better qualified trustees that go with it. That is something we have not thought about yet but would be an important thing to think about over the next year or two.
I am afraid that brings us to the end of the time allotted for the Committee to ask questions of these witnesses. On behalf of the Committee, thank you for your evidence.