Stefan Lundbergh, director of Cardano Insights, has called for “light touch” legislation to introduce collective defined contribution (CDC) schemes in the UK, allowing for a model based on existing DC schemes as an alternative to the new UK CDC regulatory framework.
In a blog published two weeks ago, Lundbergh said the biggest pensions challenge globally is to solve the pay-out phase.
“A popular vision is to introduce a life-long income but without the drawbacks of annuities, and in the UK, many advocate CDC as the solution,” he said.
But he said one of the flaws of CDC was that there is no real definition of the vehicle.
“There are so many flavours as to how it can work,” he said. “The Dutch version didn’t work – it was unnecessarily complicated and had issues with intergenerational transfers, so they decided to reform it.”
Furthermore, he said, any CDC scheme will need new administration systems, as well as large volume to create value for its members. He referred to a comment by Guy Opperman, the pension minister, that master trusts need to reach €10bn in assets, which probably also holds for CDC schemes.
Lundbergh is now proposing an alternative model to introduce the benefits of CDC while eliminating its flaws, by using existing DC industry infrastructure.
“The biggest advantage of current CDC over traditional DC is that longevity pooling allows for a longer investment horizon,” he said in his blog. “So why don’t we lengthen the investment horizon for traditional DC through longevity pooling, and avoid the complications of current CDC?”
Lundbergh’s proposed model starts with a standard master trust, which is then upgraded to offer longevity pooling, by adding a separate section for the pay-out. In its simplest form, this section would have one investment portfolio.
From a product design perspective, this would be a fairly straightforward process, he considered.
One of the claimed strengths of CDC is the almost perpetual investment horizon which allows for holding a large proportion of growth assets as well as illiquids. The latter are expected to deliver a higher return than corresponding liquid assets.
The attractive outcomes attributed to current CDC schemes assume that the alternative is traditional DC, where the member ends up taking a drawdown option, and the pension savings are invested in a less risky portfolio.
But Lundbergh argues that the long investment horizon associated with CDC can also be achieved with an add-on to a traditional DC product.
“A DC master trust with a separate section where individual longevity risk is pooled can hold the same investment portfolio as for a current CDC model,” he said.
“So when someone dies, the assets are not sold on the market – instead, ownership is redistributed among the existing members. This has attractive consequences for the investment horizon and liquidity.”
”The biggest advantage of current CDC over traditional DC is that longevity pooling allows for a longer investment horizon”
Stefan Lundbergh, director of Cardano Insights
However, he said that in this proposed approach, while longevity risk – as well as investment ownership – is pooled (so that no assets are sold on death), investment performance is not pooled.
“For a decumulation product, this makes the entry pricing more robust, since it does not involve accrued deficits or surpluses, or any assumptions about future investment returns,” said Lundbergh.
“It’s an individual account, so if things don’t go as expected, it only affects the individual, not the pool. Smoothing the individual pension payments makes them more stable if there is stock market volatility, in the same way as for current CDC.”
The individual accounting makes it more robust, said Lundbergh, in answer to questions such as: What happens when assumptions are proved wrong – how will gains or losses be redistributed? How will a discontinuation of the scheme be managed? What if the past 40 years of market performance does not repeat itself?
“In most of these cases, a DC solution with longevity pooling, implemented within a master trust, will be more robust and fair across all members, compared with more complicated CDC solutions,” he said.
Turning to the practical application of the proposed model, he observed that it would only need a very minor update of an existing master trust: “Why reinvent the wheel and make something more complicated than it actually needs to be?”
Others in the UK pensions industry think along the same lines, he added, and reactions to his blog have been supportive: “So I hope it will find its way to Guy Opperman and the Department for Work and Pensions.”
But master trusts have not yet moved in this direction.
According to Lundbergh, one reason is the legal barriers and the corresponding uncertainty, which he said could be tackled by establishing the solution as one of the CDC models in the new regulations.
“A ‘light touch’ CDC approach to the decumulation phase, based on traditional DC with longevity pooling, would be welcome,” he commented. “Combined with a clarification that DC master trusts could use a dedicated section for implementation, this would open up a low-cost solution for those members who want to have a lifelong retirement income without introducing the complexity of the current CDC solution.”
Another reason for the delay is lack of customer demand, partly because most master trust members are currently a long way from retirement.
“That is changing rapidly, so demand is likely to increase,” Lundbergh said. “As more people face retirement with DC savings only, having access to a lifelong income should be a welcome addition to the current drawdown offering.”
