Professor Catherine Donnelly is leading research into pensions products that are based on collective risk-sharing. Here she explores some of the themes emerging from the research.
At the end of January, Pensions Minister Laura Trott MP unveiled a series of measures aimed at closing the pensions inequality gap. Embedded within the plans was the latest consultation on collective defined contribution (CDC) pensions. In CDC pension schemes, both employers and employees contribute to a collective fund. They represent a third option for pension savers alongside traditional defined benefit (DB) and defined contribution (DC) arrangements.
Enabled by the Pensions Schemes Act 2021, and much debated since, CDC schemes may provide another piece to the puzzle in terms of how to provide an income which cost-effectively meets an individual’s needs in retirement, when those needs and the individual’s lifespan are unknown in advance.
The IFoA is open minded about how to provide a retirement income and has been investigating CDC schemes as a potential alternative for the UK pension saver.
Many pension savers are not saving enough. On one hand, the UK has had great success with automatic enrolment into pensions, which began in 2012. According to the ONS, in 2021 there were 22.6 million (79%) workers saving into a workplace pension. (See the ONS’s 2021 provisional and 2020 final results for employee workplace pensions in the UK).
However, a quarter (25%) of private sector workers have no pension at all, while most of the remainder (68%) have some kind of DC scheme. Very few (7%) of private sector workers are in DB schemes. Disappointingly, workers in DC schemes tend to have a smaller amount of savings than those in DB schemes.
The problem becomes more complex when we consider challenges around DC pensions and the onus placed on the individual to ‘manage their own pot’. This is particularly apparent when retirees wish to convert their DC pension savings into an income. Unlike retirees from DB schemes, DC pension savers must make an active choice of how to do this. Last year IFoA carried out some research into pensions freedoms. It was found that:
In the above context, CDC becomes a potentially attractive option. CDC schemes aim to reduce personal risk by sharing investment risk and sharing longevity risk among savers. By doing so, the hope is that people can get more certainty about their pension – how much they will get and that it will last for their lifetime – compared to using income drawdown.
There are many kinds of CDC schemes. They may be ‘whole-life’ where workers contribute to the scheme while working and are then paid a pension from it in retirement. Or they may be ‘decumulation’ or post-retirement only, where workers join at the start of their retirement with their pension pot savings. They are then paid a pension in retirement.
The IFoA is sponsoring research at Heriot-Watt University to investigate pensions products based on collective risk-sharing. (Learn more in the programme information about the research).
The main objective is to investigate how well these products can pay a stable, lifelong income to all members, using guarantees and risk management to supplement the collective risk-sharing where appropriate.
What are some of the themes emerging from the research?
Pooled annuity funds, a type of decumulation-only CDC, aim to provide their participants with a lifelong retirement income. They do this by pooling longevity risk together, using the same principle that underpins life annuity contracts and defined benefit pensions: the shorter-lived subsidise the longer-lived. By doing so, participants can gain a lifelong retirement income that is higher than under income drawdown, all else being equal.
The research suggests that pooled annuity funds should be open to new members to maximise the benefits of pooling and hence provide a more stable income stream to participants. About 100 new members are needed each year to maintain enough diversification of longevity risk over time.
It also suggests that having lots of members in a pooled annuity fund reduces most of the longevity risk.
And third, it suggests that systematic longevity risk is not a significant risk. Systematic longevity risk is the risk generated by uncertainty around the distribution of future lifetimes. It cannot be diversified away by increasing the number of participants. However, it does not contribute significantly to the total longevity risk.
The greatest longevity risk is borne by the last-joining members in a pooled annuity fund that is closed to new members. These last members do not enjoy the diversification of their longevity risk when they are old, as everyone else has died. It is this lack of diversification that is the main reason for a potentially very volatile income stream in their old age.
It is essential that suitable risk management or risk mitigation measures are put in place for these last-joining members.
Many CDC pension schemes aim to share investment risk, as well as longevity risk, among generations of scheme members. The idea is to provide members indirectly with the investment return expected over long-term periods, rather than exposing them to volatile investment returns.
Schemes that share investment risk among participants generally follow the same pattern of intergenerational cross-subsidies. Each generation passes on an accumulation of risk to the next generation. This is mostly due to the range of possible cumulative investment returns increasing over time. This may work to the financial advantage or disadvantage of each generation, depending on what happens during their time in the scheme.
Scheme design choices in CDC schemes can significantly change the intergenerational outcomes for members. There are 3 consequences of some design choices studied in the research.
First, the initial generations to join the scheme receive a much larger income than planned, when a constant benefit accrual rate is used in a whole-of-life CDC scheme. The cost of the larger income is paid for by the later generations to join, who do not benefit from it.
Second, younger members are exposed to more investment risk than implied by the scheme’s investment strategy. In contrast, older members are less exposed than the scheme’s investment strategy implies. This is entirely due to awarding all scheme members an identical pension increase on their accrued pension.
Third, a CDC scheme can follow a riskier investment strategy while protecting older members from the volatility inherent in such a strategy. As a consequence younger members bear increased volatility in their pension income. Again, this is due to sharing the collective experience of the scheme through identical annual pension increases.
The research suggests that minimising model risk could provide fairer member outcomes. By reducing model risk, there is less need to hold money back from the first generations. This means that there is less imbalance in the expected income paid to different generations in the scheme.
Longevity risk-sharing alternatives to CDC schemes, such as pooled annuity funds, may provide a similar or better outcome than the CDC scheme for many generations of members. Which one gives a better outcome depends on the design of the CDC scheme and the investment strategy followed.
Actuaries seeking more information on CDC pensions, which have sparked much debate in the profession, can further explore the outputs of this ongoing research on the IFoA website. You can access webinar recordings, pre-print papers, and blog posts at Optimising Future Pension Plans: Phase II outputs.
Join Professor Donnelly live at our next webinar which will focus on heterogeneous membership in decumulation-only CDC plans.
