Many of us have read about the sophisticated actuarial models that show the expected retirement income from a collective defined contribution scheme is around one-third greater than that generated by a DC scheme and purchasing an annuity at retirement.
That is undoubtedly great news for consumers, and especially relevant as the Department for Work and Pensions prepares to release regulations on multi-employer CDCs this autumn, to be followed in the new year with regulations for decumulation-only CDC schemes.
It is also relevant during a time when the government as a whole seems to be especially focused on getting more out of existing levels of contributions as a way of solving the pension adequacy crisis.
I decided in this piece to unpick the key sources of a CDC’s promised outperformance, just to see if they stand up to scrutiny.
We also need to remain cognisant of any potentially negative trade-offs, especially for consumers that transfer their pensions savings into a CDC at the point of retirement.
As while joining a workplace scheme is usually an obvious recommendation, it will be the adviser’s task to explain the relative merits of the decumulation-only CDC option for those transferring from DC to decumulation CDC at retirement.
Let’s look at the sources of potential outperformance first.
Higher risk, higher return growth assets for longer
The great years of UK pensions, in which final salary schemes grew to near universal coverage, and provided generous pensions to many, were built on the culture of equity investment.
And while defined benefit schemes are now mostly closed to new saving, long-term equity outperformance is not.
Vanguard Investor’s April edition showed that over the past 25 years, the FTSE All World Equity index has returned an average of 6 per cent a year over and above inflation.
This is a strong, healthy return that shows that if you invested your savings in equities, your purchasing power appreciated significantly.
Conversely, Vanguard show if you had invested in cash deposits instead, while your savings would have gone up a little in nominal terms, they would have lost more than 30 per cent in terms of purchasing power.
CDCs can expect to achieve higher growth than typical DC schemes today because they can hold more risk assets for longer. By sharing risk collectively, they can hold more growth assets than would be appropriate for one individual by themselves.
And they can hold these risk assets for far longer – probably all the way to the start of decumulation. By contrast, a typical DC scheme is set on a de-risking glide path over the past 10 to 15 years of a worker’s career.
Typically, from age 50, the DC schemes’ growth assets are steadily, year by year, swapped out for 'safer' assets. So, by retirement age the DC member is largely invested in safe rather than growth assets.
For schemes where the trustees expect the members to cash in their pot at retirement, the safe assets will be money market funds consisting of cash or near cash assets. If the trustees expect members to buy an annuity at retirement, those safe assets will be UK gilts or AAA-rated corporate bonds.
