Would collective pensions be fairer on the younger generation?

The government wants to give British workers the option of saving their money for retirement into Dutch-style “collective defined contribution” (CDC) pensions, arguing that they lead to a better deal for savers. But will they be fair to members of the younger generation?Pensions Folder

When historians come to assess the legacy of Britain’s first coalition government since the Second World War, they may well conclude that the single area of public policy where it had the biggest impact was on pension reform.

In just four years, the Coalition has implemented the recommendations of the Hutton Report on public sector pensions; introduced a single flat-rate state pension which will come into force in 2016; committed itself to raising the state pension by whichever is highest out of earnings, inflation or 2.5% each yea; brought millions of workers into new workplace-based savings schemes through auto-enrolment; and given private pension savers far more freedom to choose what they want to do with their money at the point of retirement.

However, they clearly aren’t finished yet, as one of the major policies that was announced in the Queen’s Speech which marked the state opening of parliament on 4 June was the creation of new “collective defined contribution” (CDC) pensions that will give workers another means of saving towards their retirement.

What are “collective defined contribution” pensions and how do they work?

CDC pensions share a number of features with traditional defined contribution pensions which over recent years have increasingly become the norm for British workers in the private sector. With both types of pension, the worker and the employer each contribute a certain amount, which should then increase in value through being invested. It is the savers who bear all of the risk, as they will have to live on a lower income if their pension doesn’t deliver the returns they were hoping for.

However, CDCs differ in a few important respects. Firstly, rather than investing in an individual fund where the money clearly belongs to the saver, workers pool all of their savings together into bigger funds alongside thousands of others, the idea being that this saves money on fund management and administration. Secondly, rather than taking the money at retirement and purchasing an annuity or obtaining an income through drawdown, the saver is paid a pension directly from the fund using the money invested by the other savers. Unlike with an annuity, their level of income is not fixed; it can go up or down depending on how the fund performs and the size of its liabilities compared to its assets.

What are the benefits of CDC pensions?

Proponents of CDC pensions claim they offer a number of benefits compared to traditional defined contribution pension saving plans. Supposedly, retirement incomes should be higher for savers using the CDC model because they can benefit from lower administration and fund management charges achieved through the greater economies of scale that come from sharing a fund with so many other savers. Investment and longevity risks are also pooled, because the fund is supposed to continue paying someone an income for life regardless of how long they live, and they aren’t so reliant upon the outcome of their own (or their fund manager’s) investment decisions.

In theory, retirees should also get a higher income because they don’t have to buy an annuity, so there is no annuity-provider which subtracts a profit margin, although the pension reforms in the 2014 budget made it possible for traditional defined contribution savers to avoid purchasing annuities as well.

Are CDCs better for younger generations?

Pension changes have left many of today’s young people in an extremely difficult spot. Most who work in the private sector have been hit by the closure of defined benefit (final salary) company pension schemes, although they still have to subsidise those that are available in the public sector. Auto-enrolment should offer them a viable method of saving for the long term, although it is understandable if young people are worried about tying their money up for too long when they have witnessed the rules around pension saving being changed so many times over recent years.

Theoretically, CDCs ought to offer young savers a convenient halfway-house between the generosity and reliability of the defined benefit pensions which are no longer available to them, and the risks of individual defined contribution pensions where the amount of money that has been saved can all too easily prove to be inadequate.

However, the potential problem with them is that they redistribute risk between generations.

Unlike with final salary pensions, where the sponsors of the scheme have to continue to pay full benefits to the older generation regardless of the scheme’s financial health, CDC schemes are supposed to get around this problem by adjusting the level of benefits as well as the level of contributions. Unfortunately, in practice there is still a risk that young people could be asked to pay higher contributions in order to fund benefits for the older generation; this turned out to be the case in the Netherlands, where CDC pension funds are widely used (see the article linked to above).

Whether regulators, the courts or the politicians would, in practice, allow pensioner benefits to be reduced in order to improve the funding position of a CDC scheme is an issue which young savers are entitled to feel sceptical about. This matters, because pensions rely enormously on trust; people who are saving have to believe they will be fairly rewarded one day. If young people feel they are not getting a fair deal, then they might opt to leave CDC schemes, pushing them into a death spiral of mounting liabilities and falling contributions.

Ultimately, CDC pensions have some desirable features, but they are not necessarily fairer on the younger generation than any of the other existing options would be. The issues they raise also point to the wider problem that politicians may be undermining peoples’ faith in the value of saving for the long term by tinkering with the pension system so much.

Perhaps the issue of pension reform itself could do with being pensioned-off sooner rather than later?