An earlier blog presented a Vision of Collective Defined Contribution (CDC) pensions. This presents my vision of the collective defined benefit counterpart. In common with the earlier blog, it uses the concept of the equitable interest of a member of the scheme in the scheme. As with CDC, the organisation is collective among members; there is no sponsor or external guarantor of the scheme. The role of an employer is limited to the payment of contributions as agreed with trustees1 for years of qualifying service. The employer has no liability beyond this.
As with CDC there is a ‘promised’ pension for each year of contributions. This is not guaranteed; it is not inviolable. Unlike CDC, this ‘promised’ amount is strictly capped – it is a defined benefit. Should returns exceed the implicit ‘promised’ rate, these excess assets are orphan assets held by the trust, enhancing the security of its “promises”.
If the scheme is in deficit in a particular year, that is to say that scheme assets are less than the total equitable interest of members, then pensions are not ordinarily cut. A risk sharing mechanism among scheme members kicks in. After payment of those pensions in full, the equitable interests of non-pensioner members are augmented (in proportion to their equitable interests) by an amount equal in total to excess payment. This is the quid pro quo of a risk-sharing arrangement within the differing classes of members. The equitable interest of pensioner members is unchanged. The terms of new awards for actives are unchanged from those prevailing prior. This risk-sharing arrangement has the effect of raising the effective security of active and deferred members relative to pensioners after payment of the excess pension.
As with CDC, pensioners may opt for drawdown, but that will be strictly limited to the level of funding of the scheme relative to the equitable interest, capped at 100% of that. Subject to the usual provisos, members may transfer at any time: again, based on the funding level. As with CDC, drawdown or partial transfer will lower the member’s equitable interest. This provides an incentive for members to remain in the scheme and to draw pensions as lifetime incomes.
As with CDC, the terms of the “promise” for new awards are revisited from time to time by the trustees to ensure that they are in line with expected returns from financial markets– that it is offering value for money to members.
Some have criticised the access to pension savings through drawdown or transfer as potential ‘moral hazards’. The problem in question being that members who know they are ill and unlikely to live to the population average lifespan, will draw their “pots” early, to the detriment of the collective. This certainly may be possible, but it is totally swamped by another behavioural anomaly, that we systematically underestimate the age to which we will live, with the consequence that many who should not cash in early do. The set-up of CDB does offer an incentive to remain and take the socially desirable pension payment option.
Some have argued that new members will not join a scheme which is in deficit. However, new awards, to both new members and ongoing actives, are made on the basis of the expected returns on those contributions – that they offer value for money. These define the member’s equitable interest and the value of the full pension. The level of scheme funding is only relevant with respect to transfers out of the scheme.
There is one scenario which deserves thought, that the scheme closes to new members (and possibly also further awards to existing actives), entering a long-term run-off. The first point to note is that members may withdraw the funded value of their equitable interest at any time - this is a situation in which they may be accepting lower benefits than promised. Risk sharing among the classes of member may continue, equitably, until there are only pensioners remaining. This is the point at which pensions may have to be reduced if investment performance has been inadequate. There are still a range of options other than liquidation and stand-alone run-off, such as transfer to another CDB scheme.
It is worth noting that the adjustments being made are rather small – say a scheme is 80% funded, with the pensions payable in that year being 3% of total scheme equitable interests, and that 40% of the scheme membership equitable interest is pensioner in payment, then the adjustment to active and deferreds’ equitable interests would be just: (1-0.8) * 0.03 * (0.40/0.6) = 0.4%.
While the mathematics of long versus short term investment returns may rapidly become complicated, it should be remembered that savers should prefer low prices and high associated returns. The declines in asset prices that trouble pensioners in payment add to the returns of new saving members. This is temporal smoothing which enhances compound returns.
Some have argued that CDB will require rafts of new regulation and legislation. My challenge to them is to ask them to identify the financial or economic failure that warrants any regulation.
This vision of CDB is not at all like that prevalent in the Netherlands. It really isn’t - but the rebranding of Dutch DB as CDC or CDB was just that a rebranding rather than a reconstruction of a flawed DB system. This design avoids the problems that have become evident there. One of the major lessons from the Dutch experience is that regulation of pension schemes as if they are insurance companies is a gross mistake.
1 This would be the case where the legal form chosen is a trust – other forms may be feasible but all will have officers with such a delegated power.