Does crowded pensions landscape need another form of retirement plan? - November 2021

News that the pension triple lock guarantee has been compromised caused consternation among a sizeable proportion of the nation’s older population. The promise extended to retirees a decade ago was simple enough: the state pension will increase annually by either the inflation rate, average earnings or 2.5%, whichever is the higher. However, following the publication of figures by the Office for National Statistics (ONS) which showed a rise in average earnings of almost 8%, the government had little option other than to modify the triple lock’s seemingly sacrosanct terms with a promise it will be for one year only. We shall see. 
This latest governmental intervention into pensions marks the continuation of what has been a busy few years for the sector. From George Osborne’s ‘pension freedoms’ and the much-heralded, but non-appearance of ‘Lamborghini Pensioners’, to the successful rollout of auto-enrolment and the continued replacement of Defined Benefit (DB) pensions with Defined Contribution (DC) and Defined Ambition (DA) plans. 
More recently, we have witnessed the arrival of Britain’s first Collective Defined Contribution (CDC) retirement plan, the structure of which is based on similar schemes operational in the Netherlands. But do we need another form of pension plan, particularly one which, because of the age distribution of its members, may display a bias towards equities at a time when the threat of ‘sequence risk’ has become more pronounced? 
Indeed, increasing contribution levels to workplace pensions may prove a more reliable alternative. 
According to the ONS, by the end 2020, 78% of UK employees were enrolled as members of workplace pensions. However, it’s generally accepted that their contributions must be higher as they currently cluster at minimum levels. 
A report published by Interactive Investor (May 2021) suggested that “12% was the new 8%,” ie, workplace pension contributions must rise significantly because at the lower rate of return, eventual pension levels will be nowhere near what members are expecting. 
FCA research reaffirms this. The body notes that a combination of historically low interest rates, bond yields and ‘restricted’ stock market growth resulted in the weighted real rate of investment return over five-year intervals falling between 2007-17:
2007 4.2%
2012 3.5%
2017 2.4%
One of the apparent benefits of a CDC scheme is that it can absorb greater levels of risk by investing a higher proportion of members’ contributions in equities, ostensibly because the scheme has a longer “time-horizon” than any individual saving for a pension. This appears to be borne out by Royal Mail. Its CDC plan is expected to invest 100% of member contributions in equities. 
In 2018, Royal Mail closed its DB pension scheme and in unison with the Communication Workers Union (CWU), developed a hybrid CDC scheme as a replacement. The new arrangement, introduced this year, will eventually accommodate more than 140,000 CWU members.
The scheme appears particularly generous when compared with workplace pensions. Royal Mail members contribute 6% of salary with the company contributing a further 13.6%, while members also receive a lump sum upon retirement. 
Employers carrying sizeable DB pension liabilities on their balance sheet would undoubtedly consider introducing a similarly generous CDC scheme (25% of large employers have suggested they’re likely to set up a CDC scheme by 2026), but will they prove an adequate replacement for workplace pensions? 
Supporters of CDC schemes insist they’re a compromise between DB and DC plans, suggesting that they reduce both investment and income risk for individuals. Members’ contributions are pooled, with pensions paid from the collective fund, not by an annuity. One immediate benefit is that members do not have to realise their assets when drawing a pension. 
Christine Hallett, Managing Director of Options UK, the independent SIPP and corporate pensions provider, notes several advantages associated with CDC schemes, but also strikes a cautionary note. 
“It’s reasonable to say that economies of scale, coupled with lower investment management costs, could increase members’ eventual pension income beyond what might be expected from a ‘traditional’ DC scheme,” says Ms Hallett. “Nevertheless,” she adds, “concerns have been raised about ‘inter-generational cross subsidy’, as younger workers, likely to be the majority of CDC scheme members, would effectively subsidise payments made to those who had already retired.
“Moreover, given the significant level of commitment to workplace pensions, it’s worth noting that CDC schemes only become a feasible alternative if members effectively renounce their right to withdraw pension benefits when they want after the age of 55. It’s an arrangement which appears incompatible with the much-hailed ‘pension freedoms’ introduced in 2015.” 
For younger CDC members this may not be considered a major drawback – after all, who worries about future pension income when they’re in their twenties or thirties? But a CDC scheme’s age distribution could conceivably encourage investment managers to display a bias towards equities.
Traditionally, equity performance outstrips returns from bonds, cash, gold and a host of investable alternatives over the long term. Granted, volatility is always a threat, but stock market peaks and troughs tend to be smoothed out over time, making equity returns appear favourable for investors prepared to invest for several decades, even though they may encounter some hairy moments en route. 
However, while volatility can prove uncomfortable, it is by no means the most invidious risk to pension returns; a more debilitating factor comes in the form of sequence risk. 
Sequence risk is the risk that the order (or sequence) of investment returns will prove unfavourable; it is particularly acute once funds are withdrawn, or in the case of an equity-heavy CDC pension, paid out to members. A run of poor returns in the early years of retirement can have a lasting impact upon future payments, regardless of longer-term investment performance. 
Evidence supporting this assertion can be found in Abraham Okusanya’s 2018 book, Beyond the 4% Rule, in which the author examines data compiled over 117 years, between 1900 and 2016. 
Okusaya examined every 30-year period between the two dates (1900-1929; 1901-1930; 1902-1932 etc) based upon the assumption that people live, on average, for 30 years following retirement. Prior to retiring, he assumed that they had built a portfolio comprising 50% in shares and 50% in bonds with the objective of creating a sustainable, inflation-adjusted income for three decades.
The findings showed a very strong correlation (83%) between returns in the first decade of retirement and the sustainable income for the complete 30-year period. By contrast, the correlation with returns in the second (26%) and third (-33%) decades was considerably weaker. 
Okusaya concludes that “Return in the first decade of retirement is the main driver of sustainable income over the entire 30-year period.” Sequence risk, he adds, is “the primary reason [why] someone drawing income from their portfolio is likely to run out of money, even at a modest withdrawal rate of 4% or 5%.”
The author finishes by noting that “A cash flow model assuming a net return of 3%pa will show that a withdrawal rate of 5%... is sustainable over a 30-year period. In reality, that plan would have failed in over 50% of actual historical scenarios.” 
Beyond the 4% Rule focuses upon the threats to individuals building an investment portfolio, not necessarily those facing a CDC pension plan. Yet it’s difficult to avoid the conclusion that if a new breed of British CDC plans follow Royal Mail’s proposals to invest solely in equities, (as many could, especially if members’ average age is under 45), sequence risk could negatively affect the level of payments made to retirees.