How UUK’s pension proposal could be greatly improved on, at no cost or risk to employers
A conditional defined benefit (CDB) risk-pooling alternative
In this post, I draw on the research of our employers’ own actuary to show how their offer can be improved upon by an alternative that is worse for none and better for each.
Under our employers’ proposal, they would no longer promise pension benefits of a given level for our future years of employment. Rather, pensions for future years would be based entirely on the investment returns we manage to reap on annual contributions into individual pension pots. That is why their proposal is described as a shift from ‘defined benefit’ (DB) to ‘defined contribution’ (DC).
In their justification for this shift, our employer (UUK) describes their proposal as:
the most effective way of managing USS risk, whilst simultaneously offering high quality benefits to employees….
There is, however, an alternative which involves the same level of risk and cost to employers, while at the same time providing employees with a higher expectation of pensions income at lower risk to them. This alternative therefore manages risks more effectively for all than UUK’s proposal.
On this alternative, rather than shifting all future pensions contributions into individual defined contribution (IDC) pension pots, contributions would still flow into a collective DB pension fund for salaries below £55,550. The DB pension we are unconditionally promised in retirement would, however, be much lower than the current promise of 1/75th of each year’s salary, revalued for inflation. If, however, as expected, investment returns turn out to be sufficient to fund pensions at or above the level of our current promise, we would receive pensions in retirement at this higher level. Our existing purely unconditional DB promise would therefore be transformed into a largely conditional DB promise on top of a very modest unconditional baseline DB promise. We would be promised generous pensions above this baseline, and potentially even in excess of our current DB promise, but if and only if investment returns actually meet expectations. I shall call this arrangement “conditional DB” (CDB). (First Actuarial’s WinRS proposal for Royal Mail provides an example of CDB.)
It is possible to set the unconditional DB promise low enough that the risk to employers is as low as it is under their current IDC proposal. With such a low level of employer risk, this CDB scheme would approach a form of pension provision known as collective defined contribution (CDC), in which the risk to employers is zero. However low the risks to employers, it will remain possible to pool longevity and investment risks among employees collectively, rather than for these risks to be borne individually as they are with IDC. Through such risk-pooling, both CDB and CDC are able to offer employees higher and less variable expected pensions income in retirement than IDC.
The following graph by Kevin Wesbroom, who is UUK’s actuarial advisor from Aon, models the merits of a CDC pension in comparison with a relatively close approximation of UUK’s proposed alternative:
The blue line models the pensions one would receive under CDC. The line is as high and stable as it is because it is possible, on account of risk-pooling among members of an open and ongoing scheme, to remain continually invested during members’ retirement as well as their working years in a portfolio that is weighted towards growth assets rather than bonds.
The “DC Lifestyle” red line approximates the pension income one would receive under the USS default IDC scheme into which UUK would like to move us entirely. Under this default option, individual pension pots are “lifestyle” de-risked from growth assets to bonds during the years leading up to retirement. As has been demonstrated elsewhere, this is an inefficient means of protecting against investment risk. Such lifestyle de-risking provides a large part of the explanation for why, as I have shown in another post, UUK’s proposal would yield expected pension income only 40%-75% as high as that which is promised by our current DB pension.
The CDC blue line is superior to the IDC red line, both because CDC provides a 33% higher pension at the median and because it does a better job of protecting against the risk of a very low pension. On account of these twin virtues, both employers and employees have a clear interest in improving on UUK’s IDC proposal by replacing it with a CDB pension that converges on CDC.
As I mentioned above, it is possible to devise a CDB pension with an unconditional baseline promise so low that the risk to employers is as low as it is under their current IDC proposal.* If the promise is set at that low level, we will have a CDB proposal that delivers higher expected pensions income with lower downside risks for each employee, and at the same risk and cost to employers, in comparison with their IDC proposal. Now that their attention has been drawn to this CDB alternative that is worse for none and better for each, employers would be unreasonable and irrational if they fail to endorse it.
[* Click here for an explanation of how it is possible to set the promise this low.]