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CDC - an alternative way to keep collective schemes open

  1. 1. The CDC pension alternative Henry Tapper
  2. 2. Why university pensions matter 2 Wil Sanders (1936-2002)
  3. 3. What you should expect • An income-for-life • With the security of funding • Offering sponsors value for money • Meeting member’s needs
  4. 4. Agenda for the next 30 minutes • The problems with defined benefit schemes • The problems with defined contribution schemes • The merits of an “open” collective scheme • Collective Defined Contribution schemes
  5. 5. The problems with defined benefit schemes 5
  6. 6. The problems with DB – pre-2005 • Sponsors were vulnerable to all manner of risks; ◦ Longevity expectations increasing much faster than previously allowed for in actuarial valuations ◦ Legislation imposing new costs on sponsors:  Improved preservation of leavers’ benefits, with retrospective effect  Minimum pension increases in retirement of RPI up to 5% pa ◦ The Minimum Funding Requirement meant employers had little control of their pension costs.
  7. 7. Post 2005 – a collective failure of nerve • “Back” covering • Risk aversion ◦ Coupled with poor definitions of risk • Herd mentality • Poor modelling • Employers fail to use their powers to gain a more satisfactory outcome
  8. 8. Back covering • Trustees • Scheme actuaries • The Pensions Regulator ◦ All protect their own backs by:  Asking for more contributions  Seeking to invest more in bonds at every valuation
  9. 9. Herd mentality (the received idea) • Close DB and use DC, “everybody else does” • More bonds are desirable ◦ (regardless of cost) • Pensions are bond-like ◦ (provided you are on the “flight-path to buy-out) • Actuarial valuations use a gilt yield based discount rate* ◦ (because your balance sheet’s worth it) * Other valuation methods are available
  10. 10. The impact of gilt based valuations 10
  11. 11. Employers miss their chance • The abolition of the Minimum Funding Requirement … ◦ replaced by the Statutory Funding Objective (SFO) ◦ gave control of funding back to employers • Yet the introduction of the SFO … ◦ Led to a change of funding plans … ◦ Which employers misinterpreted as a lack of financial control … ◦ Triggering another round of DB scheme closures
  12. 12. The problems with Defined Contribution Pensions 12
  13. 13. Members and employers see DC as an easy answer ) The Pension Regulator now estimate over 100,000 people transferred in 2017
  14. 14. The products aren’t easy 14
  15. 15. They can have extremely high charges 15 GAD estimate a 1% pa Pension depletes a fund By 27% over a lifetime The average transfer value in Port Talbot was £420,000 (FCA) The typical advisory charge for BSPS members was 2%
  16. 16. More problems with DC • Most individuals are inexpert in managing their own investments ◦ Vulnerable to making poor decisions of their own ◦ Vulnerable to being exploited by professional advisers • This is Hobson’s choice: ◦ High cost of non-profit annuity income-for-life ◦ Draw down has no guarantee of the pot lasting a lifetime • Inefficiency of individual investment planning ◦ Waste of time for everyone to do individually what could be done collectively ◦ No netting off of contributions and pensions
  17. 17. The life cycle of defined contribution schemes • While contributing: ◦ Investment time horizon limited by retirement date ◦ Want assets to be cheap • Big risk at retirement: ◦ From sale and reinvestment of assets into an annuity ◦ Want growth assets to be expensive and bonds to be cheap • Big risks of draw down in retirement • Money purchase is always either accumulating or decumulating, there is no open collective scheme sweet spot
  18. 18. The merits of an open collective scheme 18
  19. 19. The life cycle of a collective* scheme * Whether Defined Benefit or Collective Defined Contribution Open scheme sweet spot Benefits paid from income Infinite time horizon Market value irrelevant Scheme closed !! Closed scheme problem: Selling assets to pay benefits Shortening time horizon Buying assets Low market value good Infinite time horizon
  20. 20. Why a collective scheme should stay open • An open collective scheme has considerable investment advantages: ◦ An infinite investment time horizon ◦ Once mature, little net cash flow in or out, little exposure to short term market value volatility • Closing a collective scheme increases these risks: ◦ Disinvestment risk from net negative cash flow ◦ A finite and shortening investment time horizon • A DC scheme: ◦ Has “at retirement” risk unlike collective schemes ◦ Is either investing or disinvesting, with associated exposure to market value risk The lack of investment constraint in an open collective scheme rewards investment
  21. 21. De-risking a DB scheme • The big question: • De-risking is not only an asset side activity • If a benefit promise is onerous, substitute an easier to meet promise If an open collective scheme is better, what can we do to make it more manageable?
  22. 22. De-risking DB liabilities – step one • Suppose we decide UK equities are an attractive asset • Offer a pension of 1/80 of pay, indexed to UK equity dividend growth ◦ UK equities are the matching, low risk asset ◦ We have designed the benefits to match the assets  In a reversal of the convention of matching the assets to the benefits
  23. 23. The second step • Offer a DB pension of 1/80 of pay, with discretionary annual increases • This is the original Wage in Retirement Scheme (WinRS) proposed to Royal Mail
  24. 24. The third step • Take the WinRS design, but now allow pensions to decrease ◦ There are no defined benefit promises ◦ Communicated benefits are targets, not guarantees • Fix the employer’s contributions • Now we have a Collective Defined Contribution scheme ◦ Defined Contributions for the employer ◦ Collectively invested
  25. 25. How does CDC work? 25
  26. 26. DB valuation CDC valuation Actuarial valuation Assets Contributions Benefits Actuarial valuation Assets Contributions Benefits Mathematically the same thing
  27. 27. CDC Management process InvestmentsContributions Actuarial valuation Target benefits Member communications
  28. 28. Investments • Unconstrained – invest for a good return wherever it may be found • Not compelled to invest in growth • Not necessarily anticipating average growth returns
  29. 29. Member communications • Best estimate target benefits • Common concern that members should not be disappointed • Could also communicate: ◦ Smaller benefit with 75% probability of delivery ◦ Even smaller benefit with 90% probability of delivery
  30. 30. Actuarial valuation of a CDC scheme • Best estimate basis for inter- generational fairness • Discount rate for valuing target benefits = Internal rate of return on investments • Matches the outgo on target benefits to income from assets and contributions • You don’t need smoothing to get smoothed outcomes
  31. 31. With or without employer sponsorship? “Open access” to general public • Member’s contribution buys target benefit of equal value Single employer sponsorship • Exact value for members’ contributions not necessary ◦ Same target benefit for all members regardless of age or gender
  32. 32. Employer sponsored CDC • Defined contributions from employee and employer • Career average target benefit • Each valuation decides an annual rate of increase which balances assets and contributions with the value of benefits for both past and future service ◦ planning for an even accrual rate over time • Sometimes the accrual rate might need to change • Rarely pensions might need to be cut Assets Contributions Future service benefits Past service benefits
  33. 33. Multi-employer CDC 1. Employers can pay contributions to an “open access” CDC scheme 2. Multiple employers in a master trust can have ring fenced sections ◦ each run as a single employer CDC scheme 3. Multiple employers can share in a common target benefit pool with a common contribution rate
  34. 34. CDC for individuals and the self employed • “Open access” CDC is possible ◦ Could be provided by master trusts ◦ NEST is the Universal Service Provider for employers auto-enrolling their employees into a pension scheme ◦ NEST could open a CDC section • Open access CDC provides the self-employed with access to a pension scheme with similarities to the schemes long available to the employed
  35. 35. Find out more about CDC Derek Benstead FIA 0161 348 7451 derek.benstead @firstactuarial.co.uk Henry Tapper 07785 377768 Henry.h.tapper @firstactuarial.co.uk www.henrytapper.com
  36. 36. Disclaimers and warnings • This material has been prepared by First Actuarial LLP (FA) who take full responsibility for it • FA are not financial advisers but are regulated by the Institute and Faculty of Actuaries in respect of a range of investment business activities. • Any figures in this presentation are illustrations only and are designed to explain how investments including pensions operate. • The content of this presentation is designed to provide you with helpful information regarding and nothing in it should be regarded as providing you with any specific advice or recommendations. • If you require specific advice or help regarding your financial planning, please contact an Appropriately Qualified Financial Adviser. First Actuarial LLP is a limited liability partnership registered in England & Wales. Number OC348086. Registered address: First Actuarial LLP, Mayesbrook House, Lawnswood Business Park, Leeds, LS16 6QY 36

Editor's Notes

  • The investment advantages of pension provision from an open collective pension scheme are under appreciated in the industry today.
    Open collective scheme has infinite investment time horizon.
    Benefits out are paid from cash flow in, there is little net investment or disinvestment, therefore little exposure to short term market value volatility.

    Money purchase is always either accumulating or decumulating, it has no open collective scheme sweet spot

    Perpetual, income producing assets are natural choice
  • In money purchase, investing for a good return pre-retirement is generally accepted advice
    Despite limited time horizon of money purchase investment
    Open collective scheme has an infinite investment time horizon.
    Open collective scheme better able to invest for long term than money purchase
    e.g. budget for level target benefits from running yield on investments
    Growth in income from investments feeds growth in target benefits
  • The place for probability targets is in the communications policy
    There is no place for probability targets (other than 50%) in the actuarial valuation
  • The valuation is not the place for prudence.
    Prudence means withholding contributions from being spent on target benefits
    It’s a DC scheme: spend the contributions on benefits
    IRR: current rate of income + expectations for rate of income growth
  • Using even target benefit for all as my fairness definition.
    I can use the aggregate method to plan for evenness of benefit accrual over time.
    e.g. after one year, what is more important: balance of assets and past service target, or balance of next 10, 20 years contributions and cost of accrual?

    If accrual rate changes, operate differential increases on target benefits before/after change until equalised. E.g 1/80 to 1/90 for future accrual, freeze historic benefits for a few years until 1/90 with increases caught up with level 1/80
  • Multiple employers each ring fenced e.g. LGPS for a DB equivalent
    Multiple employers sharing in a common target benefit pool e.g. SHPS for a DB equivalent

    Clear choices for multi-employer schemes here. No need to worry about cross subsidy between employers in options 1 and 2.
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