(November 6, 2013) — A think tank has argued returns on a shared-risk defined contribution proposition can beat traditional individual funds by as much as a third.
Following a report by consulting firm Cerulli, published on November 5, which declared European asset managers had decried collective defined contribution (CDC) for being unsustainable and too costly, the UK think tank RSA has claimed returns on shared-risk plans outperformed individual defined contribution plans by 33%.
Featuring modelling carried out by consultancy Aon Hewitt, the report also found CDC plans outperformed single defined contribution plans in 37 of the past 57 years, and that the CDC plans were more predictable, lowering risks for the individual saver.
Aon Hewitt considered the position of a saver whose employer set aside 10% of their income each year from the age of 40, for 25 years. They considered what pension they would have received if they had begun saving in 1930, and retired in 1955, and in every subsequent year until 1986, when the individual would have retired in 2011, covering 57 years in all.
It compared outcomes for someone who had saved in a sample collective scheme, with someone who had put their money in different types of individual DC pensions. In particular the consultancy explored what proportion of their final salary they would receive in their retirement if they had invested in a collective plan, or an individual plan which converted to an annuity.
Aon Hewitt found that on average, the CDC pension would have produced a pension equal to 28% of final salary. The individual results varied depending on what age people retired at. For example, someone retiring in 1955 would have received only 16% of their final salary, whereas someone retiring in 1996 would have achieved 38%.
The traditional single defined contribution fund returns meanwhile, provided an average pension of 21% of final salary, and its variability was considerably greater—ranging from 9% in the worst year (1978) to more than 50% in the best (1999).
Aon Hewitt also found that CDC did not perform well in ever year between the 1930s and today, there were some periods in the 1960’s and the late 1990’s when individual DC would have done better than collective DC.
But in 37 of the 57 years, savers would have done better in a collective system.
The report then points to existing CDC arrangements outside the UK to assuage any fears over the lack of safeguards for members.
Denmark’s ATP, for example, offers a guaranteed income in respect of each payment that a saver has made. That guarantee has a value which is less than the payment which the saver has made, which allows ATP to invest the money in a way to beat the promise made.
TIAA-CREF in the US has a two “pots” system; one pot is a savings pot invested in high performing assets, the returns of which are expected to be higher, but more variable. The other is an annuity pot from which payments are made, and this is invested in lower risk assets so that pensions in payment are secure.
At retirement, TIAA-CREF savers move their money from the saving to the annuity pot, thus protecting pensions in payment.
These guarantees can have downsides however. As the report noted, one problem is that more money that is spent on de-risking the pension in the run up to retirement, the lower the overall pot size.
“Another is that the guarantee needs to be well managed and matched by investments to reduce the risk that a disproportionate amount of benefit ends up being paid to one group of beneficiaries at great cost to another group,” the report said.
“Note also that with a CDC pension, it should be possible for a member to know how much money is nominally allocated to them, and hence, in principle, it should be possible for beneficiaries to ask to move their money from one plan to another, or indeed to individual DC should they choose to do so.
“All of these elements of collective pensions need to be managed, and to sit within a regulatory framework which provides adequate protection while allowing appropriate levels of choice within a trustee managed system. The challenge for the government is to establish such a system.”
Later this month, the UK government’s Department for Work and Pensions will set out its findings on collective pensions having undertaken a year-long consultation on the issue.
“This is an opportunity to create a framework which would allow the growth of collective pensions in Britain,” the report said. “That may sound like a merely technical decision, but its impact on the retirement incomes of British people could be enormous.
“With the right choices, the young people of this country could be enjoying pensions which are 30% higher than those they will otherwise be entitled to. With the wrong decisions, our retirement system will be little more than a tax advantaged private savings plan.”
The full RSA report can be found here.
Related Content: Collective DC is Unsustainable, Say Fund Managers and Greater Illiquidity Could Boost DC Pot Sizes by 5%