Morten Nilsson, CEO, NOW: Pensions
A letter published in The Times last week by David Pitt-Watson from the Royal Society of Arts described the British pension system as being “the poor man of Europe”.
In many ways, it’s difficult to disagree. The Melbourne Mercer Global Pensions Index ranks 20 countries’ retirement income systems against more than 50 questions covering benefits, tax support, scheme design, contributions, regulation and governance among others.
The last index, published in October 2013 ranked Denmark as the top performer overall. It was the only country to receive an ‘A’ grade. The Netherlands and Australia received a B+ (see table) while the UK received a score of 65.4 meaning that it was ranked below Chile on the border of a B and C+ – a disappointing result for a country renowned for its financial services industry.
Melbourne Mercer Global Pensions Index
|A||>80||Denmark||A first class and robust retirement income system that delivers good benefits, is sustainable and has a high level of integrity.|
|A system that has a sound structure, with many good features, but has some areas for improvement that differentiates it from an A-grade system.|
|C+||60-65||Nil||A system that has some good features, but also has major risks and / or shortcomings that should be addressed. Without these improvements, its efficacy and / or long-term sustainability can be questioned.|
|A system that has some desirable features, but also has major weaknesses and / or omissions that need to be addressed. Without these improvements, its efficacy and sustainability are in doubt.|
|E||<35||Nil||A poor system that may be in the early stages of development or a non-existent system.|
One of the commonalities of the best performing countries is that they all offer some form of collective pension arrangement.
In the Queen’s speech on 5 June, changes in legislation were announced to allow “innovation in the private pensions market” with collective DC (CDC) outlined by the Pensions Minister as the centre piece of the reforms.
But, is collective DC the silver bullet it’s made out to be? Pitt-Watson says if a typical Dutch person saves the same amount, has the same life expectancy and retires on the same day, they will get up to a 50 per cent higher pension than their British counterpart.
With numbers like this, it’s not surprising that CDC schemes are being viewed so favourably. But, will they work in the UK market?
What is collective DC?
The idea behind collective defined contribution schemes is that they offer a halfway house between DB and DC.
Members pool their assets to collectively share investment risk and mortality risk and receive a smoothed return rather than a return on their individual DC account as is the case with traditional DC pensions.
CDC plans do not require members to make any investment choice or take any decisions at retirement as the CDC plan trustee board sets the investment strategy and pays out benefits direct from the fund.
A target benefit is calculated, but not promised, as the actual pension benefit to be paid is based on the funding level of the scheme – so the pension in retirement is not certain.
Because it has a longer time horizon than any single individual, advocates say a CDC plan can take more investment risk and as the cliff edge of annuity purchase doesn’t exist – money can be invested longer and members don’t suffer large capital losses if growth assets perform poorly because the returns are smoothed from year to year.
Why does it work in Denmark and The Netherlands?
Denmark, Holland and Australia are all highly unionised markets and have had mandatory or quasi mandatory pension saving for many years enabling large scale funds to develop.
The populations are relatively homogenous and the collective DC schemes operate on an occupational basis with people from similar professions sharing risk with one another – a much fairer approach than manual workers sharing risk with white collar workers as the life expectancy of these groups is markedly different.
While average outcomes in The Netherlands have typically been better than standard DC schemes, the Dutch Central Bank has said that around a quarter of CDC vehicles have had to cut benefits by on average 1.9% because of funding deficits.
There is also some dissatisfaction amongst the younger population who are effectively cross subsidising older members.
Would it work in the UK?
At the centre of all the reforms being introduced by the government is a desire to improve value for money for pension savers.
But, is CDC the answer? The UK is much more fragmented than Denmark, Holland and Australia and the scale necessary for these schemes doesn’t exist at the moment.
From a consumer perspective, the prospect of a target income in retirement is understandably appealing. Research we conducted with 2,000 people with workplace pensions in September 2013 found that the most important thing workers look for in a pension scheme is high employer contributions. But, the second most important thing was certainty over what they’ll get when they retire cited by nearly a fifth (18%).
While consumers might like the fact that CDCs offer a target pension, it’s unclear whether they will want to lock themselves up in risk sharing arrangements where there are no guarantees and there is a risk of being on the wrong side of the inter-generational cross subsidy.
If CDC schemes are to work effectively in the UK, establishing industry wide funds is a must otherwise employees could find themselves being buffeted from a CDC scheme to a DC scheme and back again.
But, convincing employers of the benefits of these schemes is going to be a tough sell. Adding greater pensions complexity at a time when firms across the country are grappling with implementing auto enrolment is far from ideal timing.
It is also uncertain how CDCs will work alongside the new pensions freedoms announced in this year’s budget. If members of collective schemes are granted the same rights to take all of their pension as cash, then the pool will shrink and become riskier for those who are still working. This could see the pension income that younger generations receive at retirement significantly reduced.
Another complicating factor is that the UK has a well-developed enhanced and impaired annuity market which can significantly boost a saver’s retirement income. But, in a CDC scheme, all members are treated the same which could result in some members losing out.
Focus on the fundamentals
With more than eight million people set to start saving into a pension as a result of auto enrolment, ensuring that their pension delivers on its promises is a must.
The government’s top priority should therefore be to address the things we know for certain have an impact on savers’ pension pots namely the level of contributions made, the charges imposed and the design and performance of the default fund.
Get these fundamental things right, and savers will see a significant uplift in their income in retirement without the need for further complexity in scheme design.
While collective DC is proven in other markets, in the UK it feels as though we are trying to run before we can walk.
Changing the legislative framework to accommodate greater innovation and flexibility in the pensions industry in future makes good sense, but for now the focus needs to remain firmly on delivering value in DC schemes as this is where the majority of employees will find their money invested for the foreseeable future.