Shh – it’s a secret…

I deliberately omitted the ‘P’ word from the title because I don’t want you to skip this article, <firstname>.

A recently passed Act of Parliament with the not very exciting name of the Pension Schemes Act 2021 heralds what could be a revolution in pension provision for UK based retirees. As with so much in the financial world, you only find out about it if you are connected to the right sources of information – like the Beaufort Society!

The Biggest Pension Change Since the 1980s

It’s the biggest change in pensions provision since the 1980s when Margaret Thatcher introduced the Defined Contribution (DC) scheme as an employer-friendly alternative to Defined Benefit (DB) schemes. That had the effect of turning each of us into a fund manager, whether we liked it or not. And whether we had any aptitude for it or not…

At the heart of the problem is a design flaw. If we agree that the purpose of a pension is to provide a regular income from the moment we retire to the time when we take our final breath, DC schemes fall well short. They are simply a tax advantaged saving scheme, riddled with traps laid by successive chancellors trying to further reduce the incentives to be self-sufficient in our golden years.

Invest well and you will hit your head on the ‘Lifetime Limit’, set at just over £1 million – as if that represents enough to live a life of luxury in 21st century Britain! Try buying an annuity with inflation protection and second life cover for your spouse and you will see how far a million quid goes these days. Dare to go over the limit, or to contribute more than you are supposed to, and you’ll be hit with a punitive 55% tax bill on the excess.

Those are just some of the problems the current system creates in the ‘accumulation’ phase. The next set of problems occur when you decide it’s time to reap the rewards of a lifetime of thrift. I guarantee you will rule out the annuity option when you see the pathetic returns on offer. (OK they are improving slightly as interest rates rise but not enough to counteract inflation).

Can You Predict How Long You Will Live?

So, drawing down some of your savings while leaving the rest invested is likely to be your only choice. But how much do you draw down each year? That very much depends on how long you think you are going to live. The pleasant surprise of living longer than you expected might be offset by the realization that you’ve run out of cash!

This is where the revolution comes in. There’s only one extra word in the title but it transforms the design and the functionality of the process to make it a win for retirees and a win for their employers.

The new breed of pension, available for the first time ever in the UK, is the Collective Defined Contribution (CDC) scheme. It’s a hybrid between Defined Contribution and Defined Benefit in that it does NOT provide a guaranteed sum but it does guarantee an income for life.

The lack of a guaranteed payment means that employers avoid the DB shortfalls that have caused so may problems for large companies who hit challenging times and cannot maintain contributions at a level that meets historic obligations.

CDC Should Produce 30% Better Returns

Yet it is that very lack of a guaranteed income that enables the scheme to avoid the low interest bonds that usually underpin pension commitments and make better investments in assets such as equities with a higher return over a long period.  Countries like Holland, Canada and Denmark have used this approach for years and seen an average 30% better outcome for pensioners than with individua DC schemes.

Investments are made collectively and, while it’s impossible to predict the lifespan of an individual with any accuracy, actuaries can forecast life expectancy of a large population with much more certainty. So, if you live longer than expected, the pool of funds is there to keep supporting you.

In a sense it’s a mirror image of life insurance, where the collective nature of the investments and the economies of scheme administration mean that you can insure against an unexpectedly longer time on earth rather than taking care of your nearest and dearest if you hit the snooze button sooner than you planned to.

An Extra Trillion Added To Pension Savings

No scheme like this could be immune to macroeconomic circumstances, so payments can be reduced in extremis as happened after the 2008 financial crisis. But this is rounding factor compared to the potential of a 30% improvement in the performance of your pension fund. Brits already have £3 trillion salted away in pension savings – the move to Collective Defined Contribution schemes could increase this by another trillion. Even in these days of central bank profligacy, that’s not exactly chump change…

Royal Mail is the first big company in the UK to implement a CDC scheme for its 100,000 staff – maybe this new perk will encourage them to start delivering the occasional letter again? They will use the current single employer version of the new structure but the even more interesting next step is the multi-employer CDC where the collective part is spread across more than one company.

Your Children Will Be The Biggest Beneficiaries

There’s a consultation going on at the moment which should lead to legislation enabling multi-company CDC schemes next year. It may be too late for those of us already in the latter stages of pension planning, but for millennials and Gen-Z with decades of work ahead of them this really is the best news in forty years.

And yet it’s lost in the noise of a leadership election, an energy crisis and inflation at seventy year highs. Make sure your children (and their employers) are aware of CDC schemes as they could make the difference between a comfortable retirement and a daily search down the sofa for enough cash to cover a McDonalds burger.

Oops, sorry I forgot – they just went up by 20%.

Until next time.