Stephen Nichols Personal View
Issued on: 22 November 2010
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The case for collective DC: a defined benefit for a defined contribution |
How many times have you heard it said that “defined contribution schemes only produce an inferior benefit compared to defined benefit schemes because the contribution rates are lower? If identical contributions were invested in both schemes the outcome would be the same”. – Wrong!
This is perhaps the biggest myth in pensions, and one that I would admit to having said myself. That was until the day I sat down with a calculator and did some basic sums; the results of which were quite surprising. Having researched this further, it is not just me that has realised that the difference in final benefits can be as much as 50%. This is due to the relatively high annual management charges typical in defined contribution arrangements coupled with the constrained investment approach that needs to be adopted by individuals, particularly as they approach retirement. Whilst I am a supporter of NEST, NEST savers will be even worse off with the proposed 2% initial charge and the ‘politically safe’ bond only investment strategy. – Have I got your attention?
As an employer, what are the alternatives to potentially wasting 50% of your pension budget – surely not defined benefit again? – Tried that, too many risks and am now struggling to cope with a huge corporate burden (a.k.a. pension deficit).
You’re right, we cannot remove all the employer risks associated with defined benefit (at least not at the moment but this may change …see below). However, we can reduce those risks considerably if we acknowledge that: 1) the conditions during the last century that enabled defined benefit pensions to flourish are unlikely to return, and 2) we pay attention to the unrewarded risks, such as, inflation, interest rates and longevity i.e. we start, with our eyes wide open, with a pricing model and investment strategy suitable for the 21st century.
Remarkably, with this in place a Career Average 1/120ths with CPI revaluation on ‘banded earnings’ to satisfy auto-enrolment requirements is affordable for little more than the minimum contributions to NEST, and it is capable of delivering much higher benefits for members. – Tempted, but the risks still too high?
Well, what if we could provide the above benefits with the employer taking no greater risk than operating a defined contribution scheme, i.e. the employer just paying a fixed contribution. – Would that be a benefit design worthy of investigation?
This could be possible if the defined benefit promise could be reduced through say negative indexation to match what can be afforded from the accumulated assets and future contributions. – That’s right, all the advantages, none of the risks - a defined benefit, for a defined contribution.
These scheme designs do exist, but not in the United Kingdom. You would have to go to the Netherlands to see them in operation, and they are more commonly known as “Collective DC Schemes”.
The DWP rejected Collective DC Schemes in 2008 citing drafting complexities and lack of demand as the main obstacles. – Not that it would be a direct competitor to NEST!
Fortunately, we have been given another chance – Lord Hutton is due to re-pitch Collective DC and other innovative risk sharing schemes as part of his Public Sector Pension review. Don’t let this opportunity escape us once again, join in the debate and demand that whatever is agreed for the Public Sector is also permitted in the Private Sector.
Perhaps defined benefit is worth saving after all.