A collective defined contribution scheme, which pools together assets from multiple companies, has much to recommend it. It’s no longer effective for many companies to set up their own DC schemes – it requires too great a commitment from the executive team.
In addition to saving management time, collective schemes can do things than it’s much harder to do on a smaller scale. The most obvious is to make use of their scale to negotiate better rates with providers. Economies of scale also mean collective schemes can afford to hire a specialised risk management team to mitigate threats from interest rates, inflation and equity market volatility.
The investment horizons of a collective scheme can also be broader than a smaller scheme. If there is a constant supply of new members in the scheme then it is much easier to invest in illiquid asset classes like infrastructure and property as there can be an effective internal market. As members retire, younger members can acquire those assets at a fair market price.
These types of collective DC schemes already exist, principally in the form of master trusts. And other forms of collectivised schemes might well come into being in the future.
It’s less understandable why the government wants to introduce a collective defined contribution scheme, which would be based on collective risk sharing. A slew of angry emails have landed in my inbox, which can be broadly summarised as saying: “We have done this before. It was called with-profits. And that did not end well.”
At first glance, the appeal of CDC is understandable. In addition to economies of scale, it’s hoped that with a larger population, these schemes might be able to take on more investment risk and thus obtain higher returns. But as collective scheme members in the Netherlands discovered, collective risk sharing provides no guarantee. Returns might well not live up to expectations and benefits would have to be cut.
And there’s another aspect of CDC that I find particularly jarring: its insistence on a fixed contribution rate. In theory, the fixed rate is supposed to offer stability to scheme members.
But in this post-Budget world, where the abolition of compulsory annuity purchase heralds a return of choice to the pension market, taking control away from the scheme member about how much they can pay into their pension is inconsistent with this new world order.
Increasing contributions is one of the easiest and most effective ways for scheme members to improve their retirement income. Setting contributions at a fixed rate sends the wrong, and potentially dangerous, message: it implies that a good retirement income is entirely dependent on investment returns rather than the amount funnelled into a pension.
Master trusts are far better collective solution. Their scale translates into more cost effective solutions along with an ability to manage risk better and invest in illiquid assets. All of this can be achieved while ring fencing an individual’s assets and without the belief that collectivism somehow equates to a free lunch.