Written evidence from APG Group (CDC0010)

1. Executive Summary

• CDC is an excellent alternative for providing good and affordable pensions.
• CDC schemes will be beneficial for participants because of risk pooling, lower costs and better income security given an agreed level of contributions.
• CDC schemes will be beneficial for employers because of risk mitigation (no open ended pension risk) and cost transparency.
• Dutch international corporations provide good examples for CDC scheme design.
• CDC allows for tailor made solutions and may include freedom of choice in payouts for participants while maintaining the collective nature of the scheme.
• The long term investment horizon of CDC funds allows for investments in long term assets such as infrastructure and gives access to better portfolio diversification.
• CDC in itself will not solve underfunding but will allow corporates to start afresh with a pension plan with a sustainable design.

2. Introduction

Providing good and affordable pensions is important to help workers, companies and government deal with the challenge of providing adequate income for the elderly. This will allow workers to retire and companies to create the workforce they need in a competitive and innovative economy by replacing retiring workers by newly trained young employees. A Collective Defined Contribution (CDC) pension scheme is an example of a new pension contract that is able to provide good and affordable pensions for both workers and companies. CDC schemes offer the benefits of collective investment and risk sharing among participants within the scheme and at the same time allow social partners to agree on the necessary contributions for the scheme thereby avoiding open ended liabilities in the future. The pooling of investment, inflation, mortality and longevity risks within the scheme will allow for better outcomes for participants in a CDC scheme compared to individual accounts where participants bear these risks themselves (see e.g. De Haan et al. (2016)[1], Blake (2016)[2], Popat et al. (2015)[3]). This type of risk sharing is common in the Netherlands where many corporate schemes have introduced CDC schemes in the last 10-15 years. These schemes are similar with respect to risk sharing, but allow for corporate specific design with regard to the accumulation and decumulation phase. Some CDC schemes offer (deferred) annuities while others offer individual accounts in the accumulation phase. Risk sharing in corporate CDC schemes is comparable to risk sharing in multi employer industry wide pension schemes in the Netherlands. In 2017 the coverage ratios of Dutch pension schemes improved to circa 108% according to a recent AON survey on Dutch pension funds.

3. Benefits to savers and the wider economy

3.1   Would CDC deliver tangible benefits to savers compared with other models?

CDC schemes benefit both employees as well as employers. The risk sharing within the CDC scheme of investment, inflation, mortality and longevity risks allows employees to experience less volatility and uncertainty with regard to future pension outcomes. The risk sharing allows for smoothing of volatility within the group of participants and over time. Furthermore, participants may benefit from collective investments for the long term, the use of a broader range of capital market and other investment options and lower costs available to large institutional investors. Corporates benefit from the transparent and clear agreement on the actual contribution, the lack of open-ended future liabilities and more secure pension outcomes. The latter will allow workers to retire with more income security which is beneficial for productivity in the later stage of their careers. CDC funds will have access to a broader range of long term investments such as infrastructure that also offer additional diversification advantages and may benefit the economy.

3.2   How would a continental-style collective approach work alongside individual freedom and choice?

Individual freedom and choice to allow for tailor made solutions are possible in a CDC scheme. In the Netherlands optionality exists with regard to the pay out phase (early retirement, retirement date, survivor’s pension, flexibility in pay outs). Actuaries calculate the impact of individual choice so that it is actuarially fair. Currently, part of debate concerns the use of small lump sums. CDC schemes with individual accounts in accumulation phase also allow for investment choice, although the experience is that in case of personal investment choice most participants prefer the use of defaults. So, it is possible to include individual choice to allow for tailor made solutions

3.3   Does this risk creating extra complexity and confusion? Would savers understand and trust the income ‘ambition’ offered by CDC?

Communication of pensions and financial literacy are enormous challenges that need attention since more risks are shifted to individuals. Many participants in DC schemes have difficulty in making choices, understanding what amount of capital they need for retirement and understanding the complexity of annuities. For CDC some of these issues are better addressed because the CDC scheme is designed towards a future income ambition. Participants may be better able to understand an expected pension outcome than an expected pension capital. Effective communication on the risks involved in the CDC needs proper attention. Providing a digital infrastructure that gives participants access to their accrued future pension income, investment data and financial planning tooling will help, but as in other schemes it will be a challenge to make people knowledgeable on pensions.

4. Converting DB schemes to CDC

4.1   Could seriously underfunded DB pension schemes be resolved by changing their pension contract to CDC, along Dutch lines?

CDC in itself will not solve the issue of underfunding.  In those cases it should be discussed who is able and willing to bear the cost of underfunding (e.g. sponsor, participants, otherwise). However, it is possible to close an existing plan and start a new CDC scheme next to an existing scheme. A plan can be set up for the closed scheme which may include the transfer of pension rights to the new scheme. An important advantage of the new CDC scheme is that future pension accruals can continue without the immediate burden of the closed scheme. In the Netherlands, several large international companies have introduced new CDC schemes next to the old scheme which was closed (or closed to new participants).

4.2   How would this be regulated and how would the loss of DB pension promises to scheme members be addressed?

In the Netherlands CDC schemes and DB schemes are regulated in a similar way. In Dutch regulation proper communication of the scheme characteristics and the expected levels of indexation and downside risk are emphasized.

In several cases where corporate pension schemes have moved from DB to CDC social partners have agreed on a one-off additional contribution by the corporate to the pension fund.

5. Regulation, governance and industry issues

5.1   How would CDCs be regulated?

CDC schemes are regulated in a similar way as DB schemes in the Netherlands. Compared to DB schemes the risk management of the scheme lacks the instrument of additional corporate contributions in case of underfunding (as well as the possibility of pension (contribution) holidays in case of overfunding).

Since participants are pooling risks, it is important that the governance of CDC schemes receives proper attention so that the funds are managed efficiently and to the benefit of the participants.

5.2   Is there appetite among employers and the UK pension industry to deliver CDC?

Several Anglo-Dutch and international companies have experience in the field of CDC. For companies the war for talent will require competitive benefit packages in which retirement benefits are an essential element. For companies it makes sense to set up sustainable pension schemes in order to allow older workers to leave the company in time to be replaced by younger workers. The outlook of more secure retirement benefits will also improve productivity for active workers as is shown by research of benefit consultants (e.g. PwC, Willis Towers Watson (2016)[4]).

5.3   Would CDC funds have a clearer view towards investing for the long term?

CDC funds are collectively invested funds with a long investment horizon. Their aim is to provide secure lifelong retirement income which means that the investment horizons are long (and increasing given longevity). This allows for the use of illiquid investment asset classes that generate long term cash flows and a focus on responsible investing. Asset classes like infrastructure would fit this profile since these are typically long term. Therefore, CDC funds would benefit from the supply of private infrastructure financing opportunities both domestically as well as international. The long term nature of pension liabilities would also provide demand for other long dated securities (nominal and inflation linked). It is to be expected that other asset classes that add to diversification but are not common in individual portfolios are available for CDC funds of a certain size at institutional pricing levels (see also Ambachtsheer (2016)[5] for long term investing).

6. Recommendations for action

• CDC pension schemes offer an important alternative to current DC of DB schemes in the UK. The implementation and use of existing legislation will provide a new hybrid solution combining the best of DC and DB.
• Experience in pension communication and behavioral research in the UK can be used in CDC design to make sure that plan participants and employers understand the pension deal.
• Education of / workshops for social partners would help both employees and employers with an adequate preparation and pension scheme negotiation process for new CDC schemes.
• Experience in CDC design in the Netherlands offers fertile ground for further knowledge exchange. An effort can be made to learn from the actual implementation by a visit of experts to these funds.

Annex : Background information dr. Alwin Oerlemans, CFA, FRM

His focus is on pension asset & risk management and international pensions. He has been at APG since 2006 in positions in strategy and business development. Before APG, he worked for 9 years at merchant bank NIBC where he was involved in financial markets and pension fund risk management and 5 years at the Treasury of the Dutch Ministry of Finance in The Hague. He is chairman of the APG Personnel Pension Fund, takes part in the Editorial Boards of several pension publications and regularly teaches on pension management and innovation.

He holds a masters degree in Operations Research and Econometrics from Erasmus University Rotterdam, a PhD in Quantitative Economics from Maastricht University and is CFA and FRM (Financial Risk Manager) charter holder. He has written several articles on pension design, risk management, governance and IORPs.

APG is specialised in the administration of collective pensions and serves over 4.5 million pension fund members in the sectors education, government, construction, cleaning and housing corporations. APG manages over €440 billion of pension assets and has offices in Amsterdam, Heerlen, New York, Hong Kong and Brussels.

January 2018