a false dawn for pensions

This week was a landmark for UK pensions, with the launch of a new group pension arrangement offering the potential for better retirement outcomes for millions of people.

On Monday, Royal Mail became the first UK employer to offer staff a collective defined contribution (CDC) pension, six years after it was first announced.

The government has also published plans to boost CDC take-up by allowing multiple employers to join a single plan, unlike Royal Mail’s single employer plan.

The CDC appears to offer a larger and less risky pension than the individual DC, as well as incentivizing investment in UK private assets. But can it really do what it says on the tin?

Employer-guaranteed private sector defined benefit (DB) pensions are all but gone, replaced by defined contribution (DC), people save in individual pots and take their own investment and longevity risk.

The CDC sets an annual “target pension” based on the value of assets from employee and employer contributions plus investment returns. Target pensions are not guaranteed, but can increase or decrease each year – including for pensions already paid – depending on the value of assets.

To fund its ambitious growth plans, the government is trying to push pensions into Britain’s “productive assets” and hopes the CDC will be another pool of money to be invested in infrastructure, start-ups and private equity.

In 2023, the main pension providers signed the Mansion House Compact to allocate 5% of assets in ‘default’ DC funds to private assets, and the government hopes around £50bn will be invested by 2030.

How much CDC could raise this target depends on CDC uptake and private asset allocation.

Since Royal Mail’s announcement six years ago, no other company has signed up to the CDC and no pension provider has said it will set up a multi-employer CDC.

Let’s say 10% of DC assets move to CDC and CDC owns 10% of private assets, double the Mansion House DC target. DC and CDC global private assets would only increase to 5.5%, barely moving the dial against DC alone.

But CDC fans argue that it can hold a much larger share of riskier assets than DC because of “intergenerational risk sharing,” when members of different ages pool investment risk and longevity.

This statement gets to the heart of the CDC error. For any asset allocation, CDC investment risk is exactly the same as DC.

Generational risk sharing is a myth because legislation prohibits “buffers” to “smooth” the results. CDC plans are not allowed to hold assets in a buffer, be released when returns are weaker than expected, or added when returns are better than expected, as with discredited “with-profit” policies.

If the CDC’s assets fall by, say, 20%, the target pensions also fall by 20% for all members—an 80-year-old retiree or a 30-year employee.

It is exactly the same as a DC saver with its own pot. If assets drop by 20 percent, their “target pension” drops by the same amount.

We should not buy into the false promise of better retirement outcomes by switching to complex, opaque and expensive CDC pensions

Identical contributions and identical asset allocation produce identical CDC and DC returns, but of course CDC comes with higher management costs. The government should not expect the CDC to hold more private assets than the DC.

CDC also imposes the same asset allocation on all members, regardless of their age or risk preference. DC gives everyone the flexibility to choose their own level of investment risk, which can change as they approach retirement.

What about Royal Mail’s CDC? It has 6% member contributions and 13.5% employer contributions, providing an inflation-linked target pension of 1/80 of salary, plus 3/80 of cash, from age 67. Over 40, members could earn a target pension of half the average. salary, plus a lump sum three times the pension.

But that seems unexciting – at current inflation-adjusted long-term gilts rates, that’s an average return of just gilts plus 1%. A DC saver could achieve the same “target retirement” by holding low-risk government securities and corporate bonds, with just a few higher-risk stocks.

CDC has really always only been attractive to the few private sector companies that still offer DB, not the overwhelming majority with DC. But now that the annual cost of DB pension promises has been reduced, thanks to much higher long-term interest rates, these companies have no incentive to close their DB pensions and jump into the CDC-unknown.

Although there are no ‘magic beans’ in Royal Mail CDC, what sets it apart from ‘normal’ DC is the generous 13.5% employer contribution, higher than most top companies and well above the statutory minimum of 3 %.

And total contributions of almost 20 per cent of salary are enough for Royal Mail staff to build a decent DC pension pot and a decent pension.

We should not fall for the false promises of better retirement outcomes by switching to complex, opaque and expensive CDC pensions. The only real way to improve pensions is with simple, transparent and cheap DC pots and higher contributions.

John Ralfe is an independent pensions consultant. X: @johnralfe1