Without further ado, I'd like to welcome Michael Otsuka to deliver his second lecture.
All right. Thank you very much, Julian, and I'm glad to be back.
So I drew last week's lecture to a conclusion with an account.
I'm trying to see if I can. Right.
It drew last week's lecturer's two conclusion with an account of the virtues of a form of insurance
created by the joining together of a number of different corporations into a mutual association,
namely last man standing multiemployer pension scheme.
And so here we have what we might describe as a social union of social unions, to borrow a phrase from John Rawls.
So the employer covenant is rendered strong and enduring through the binding together of universities and colleges up and down the country.
And this is because such collectivisation allows for the spreading of risks of insolvency across all universities and colleges in the land.
And it also underwrites the risks of an vestment in growth assets through the spreading out
of the costs of recovery from market downturns over decades and therefore across generations.
Now, as was noted in the discussion following my last lecture,
Last Man Standing form of neutrality raises some concerns of intergenerational fairness.
So if the cost of recovery from the underfunding of past pensions promises as spread out as I proposed over the next three decades.
Then younger workers in the case of USAC who didn't receive such generous promises will be forced,
at least indirectly, to bear some of the costs of making good these promises to previous generations.
And then questions of fairness also arise amongst members of the same generation.
So as the University of Cambridge said in their submission to the 2017 USS Consultation on the valuation, quote,
University and other financially stronger institutions continues to lend its balance sheet to the sector,
which contains the cost of pensions provision for all employers.
Now, I noted last week that Trinity College, Cambridge, the financially strongest of all of USSA sponsors,
recently arranged a costly exit from the scheme to limit the exposure of their asset
rich balance sheet to the risk sharing mutuality of this last man standing arrangement.
And account of these concerns of unfairness to which this spreading of risks across space and time gives rise.
It will, I think, be useful to consider the alternative of providing pensions in a manner in which all
costs and benefits are fully internalised by the individual who receives the pension.
So I shall therefore begin this lecture at the other end of the spectrum from the large last man standing social union of social unions.
What I'm gonna do is start today with the consideration of a stripped down, highly atomised, individualistic form of pensions provision.
This will serve to identify the different challenges with which we're faced in providing for our
old age and also the range of solutions available from this individualistic starting point.
What I'm going to do today is build back up finally to last week's highly collectivist form of pension provision.
And in doing this, I hope I'll be able to clarify the workings and functions of the various integrated parts of a collective scheme.
And what we shall see is that there's an interesting range of possibilities that lie between the starkly individualistic.
And higher, they call collectivist forms of pension provision, so to speak.
Different degrees and forms of collectivisation. Question,
might there be an optimal point somewhere between these two ends of the spectrum which solves the problems of individualistic pension
provision without taking on the vices attributed to highly collective pensions provision that I mentioned a few moments ago?
And that's the question I shall ask today. Is there some optimal point between these two extremes or shall we take one the two extremes?
Well, let me begin. With the observation that pensions provision is not essentially intergenerational or even social in nature,
so it can arise even if we restrict ourselves to a single generation and within that generation to a single isolated individual.
Now here, the problem of how to provide for one's old age would be especially acute.
So we can imagine a Robinson Crusoe like character stranded alone on a desert island.
Who knows that she'll never be rescued. And although she's now capable of roaming the island to gather food and sustain herself,
she realises that she will one day grow too old and infirm, indeed, to retire to a more sedentary life.
Now she knows that she'll die of starvation if she doesn't make provision while she's mobile and active for sustenance in her old age.
Now, in trying to provide for her, so to speak, retirement on this desert island,
she faces the two risks that render pension provision difficult for all of us.
That's longevity risk and investment risk. Her longevity risk is that of not knowing how long she'll live in a condition of infirmity,
in which she's no longer able to roam the land to gather food on this island.
No. On the one hand, she wants to make sure that she's made enough provision to consume so that they last as long as she would
live in this infirm state to the point where she managed to die of something other than starvation.
Now, on the other hand,
she wants to make sure that she doesn't expend unnecessary time in labour making provisions that will outlast her and go to waste after she dies.
Now and grappling with what we can call the other risk, investment risk.
She will need to decide which things to gather on the basis of her knowledge of how well they will keep before they spoil.
So we can also imagine. That she has choices involving positive returns on investment.
For example, the planting of a garden that will continue to bear nearby fruit when she's no longer able to roam
or more fancifully the fermenting of drinks that will maybe improve with age during her retirement.
Well, the increasingly prevalent means of pension provision in contemporary society shares,
I think some of the flaws of this primitive, individualistic.
Do it yourself. Method of desert island pension provision. I've just sketched.
So what I'm referring to is the familiar and increasingly common individual defined contribution retirement savings plan known as a four oh one K,
and you had states, D.C. pension pots and United Kingdom works roughly as follows you.
And typically also your employer make monthly contributions into your pension pot during your working years.
These contributions are typically set as a fixed percentage of your income and then you decide how to invest that part.
And then when you retire, you make use of your pension pot to provide yourself with an income in retirement.
Now, increasingly, the way that people are choosing to do this is by income draw down by drawing down their
fun by means of withdrawals from a continuously invested part until it's depleted.
And treating the pension pot like a big A.T.M. machine. No, such a practise of income drawdown involves significant exposure to longevity risk.
And here's why. If you knew exactly how long you would manage to live in retirement, you could budget to cover precisely that number of years.
But one typically doesn't know the date of one's death.
So if you're a British man. A woman eligible for a full state pension.
Your mean life expectancy is 19 more years to the age of 85.
However, if a one in four chance of living seven more years beyonder to the age of 92 and a one in 10 chance of living to the age of 96.
Now, if you're a 66 year old British woman, your mean life expectancy is 21 more years to the age of 87.
However, you have a one in four chance of living to ninety four and a one in 10 chance of living to ninety eight.
Let's suppose that you're a British woman chosen to retire at the age of 66 and you're in possession
of no information that would differentiate your prospects from that of any other 66 year old woman.
Question, how should you decide if you're trying to draw down your pension pot in retirement?
What portion of your pot to draw down each year?
Should you assume you're going to live the mean number twenty one more years and therefore try to decide divide your pension pot into 21 equal parts,
one for each year? Well, if you do that, there's actually greater than 50 percent chance that you'll deplete your pension pot before you die.
Since the median number of years, a 66 year old is somewhat higher than the mean number of years.
Now, in order to ensure a very high chance, a 90 percent chance that you'll have a regular income until death,
you're going to need to divide your PA into 32 equal parts, one for each year until the age of 98.
If you do that, you're going to run a very high chance that you will not be able to take full advantage of your pension pot during your lifetime.
You'll leave money on the table.
So you're running a dual risk of your money running out before you die of having left much of your pot and consumed at death.
Now, in each case, had you known how long you would live, then you would have made different choices regarding the pace of your withdrawals.
Even now, her. It's actually up.
No press plea. How long you're going to live in retirement?
Let's assume that, you know, you'll live exactly 21 more years.
You're faced with a further problem that it will be difficult to divide your path into 21 equal portions unless you invested very conservatively.
Well, first note that the equality of the portions should be in real rather nominal terms,
which is to say that they should be equal once one adjusts for any decline in purchasing power due to inflation.
And one would actually need to invest in inflation index linked bombs or derivatives that hedge against
inflation to try to bring about a division of 21 parts that are equal in real terms and second,
investments with high expected return.
Our purchase of the costs of a relatively high risk involving unpredictable variability of outcomes and therefore,
unless you invest very conservatively in a manner that simply hedges against inflation,
it will really be impossible to know how much to withdraw each year in order to
ensure that you receive equal income in real terms throughout the rest of your life. Even if you know precisely how many years.
You have to live.
Now, on account of all these difficulties, the financial economist and Nobel laureate William Sharpe has described income drawdown as,
quote, the nastiest, hardest problem in finance.
It is, however, a problem that increasing numbers of retired individuals and United Kingdom,
United States and I think increasingly elsewhere face on their own,
both as defined contribution pension pots become more and more prevalent, as does income drawdown,
as the way to try to transform these pension pots into retirement income.
Today, I'm going to consider the workings and merits of an interesting and innovative solution to this nastiest,
hardest problem in finance, and this solution will soon be provided to the postal workers.
Royal Mail and hence the pillar boxes and my title slide.
The solution bears the name of C. D.C.
Now, various critics regard CDC as a disease that needs to be controlled before it has a chance to spread beyond postal workers.
The CDC stands for collective defined contribution, doesn't stand for centres for disease control, not at least today.
Now, some oppose CDC because I regard it as an unsound alternative to existing
individualistic forms of defined contribution IDC that I've been talking about.
But others opposed it for a very different reason, because they regard CDC as a threat to defined benefit.
Now, the USS pension scheme, for example, has often been mentioned as a prime candidate for CDC.
Now some welcome. CDC as a solution to USSS problems.
Others oppose it as an existential threat to the existing beleaguered DB scheme.
So question, should CDC be welcomed or should it be repelled?
I hope to shed light on that question today.
But before directly talking about CTCA, I want to establish a point of reference, the benchmark against which we can measure it.
Did you, son? I'm going to begin with a sketch of the traditional manner in which individuals with defined contribution pension pots have in the past.
Address the problems of longevity and investment risk.
It was once common for an individual to enter into the following market exchange with an insurance company at or near the point of retirement.
So you agree to transfer the assets you've accumulated in your pension pot?
Barron's company, and in exchange, the insurance company provides you with an annuity,
which is the guarantee of a steady stream of income from retirement until death.
With or without increases to partially or fully cover price inflation.
Given that sort of annuity purchase and therefore, through this purchase of an annuity,
you transfer all longevity and investment risk over to the insurance company.
Well, here's how the insurance company. Is able to handle longevity risk,
and this is also how collective pension schemes and longevity rich much more effectively than an individual can handle longevity risk.
So as I remember, as I mentioned earlier, for someone in the U.K. who now retires at the age of 66.
One's average life expectancy is about 20 more years, 19 for men.
21 for a woman. Now, no individual who's attempting to draw down her pension pot on retirement on her
own can safely assume that he or she will live this average number of years.
For all she knows, she might live anywhere from one to 40 years beyond the date of retirement.
And as I noted earlier, this uncertainty makes it very hard to gold.
Let's bring in John.
But by the law of large numbers, however, an insurance company which writes annuities for a large number of individual are the same age.
We're retiring at the same time. Can safely assume that the different lifespans will average out to something very close to 20 years.
This figure in this case is statistically stable.
Just to say there's a low degree of variance when we apply it to a large population and therefore the insurance company can can budget.
Precisely. Now, that's how an insurance company handles longevity risk.
And here and I talked a bit about this last week, is how much union budy handles investment risk.
Insurance companies required required by solvency regulations to have sufficient capital to
insure that as a ninety nine point five percent chance of paying out the promised annuity.
And to achieve this level of certainty,
it invests in assets that come close to perfectly matching the pensions liabilities in their duration and magnitude.
A long dated, inflation linked government bonds come closest to this match.
As I mentioned, last week's lecture is for this reason that the cost of an annuity closely tracks the government bond yield,
which has been falling as the graph show.
And since these yields are now extremely low right hand side of the graph, the cost of an annuity is now very high.
Now, well, it's possible, man, or I've just described for an individual to eliminate investment and longevity risk by
means of purchase of an annuity in exchange for his pension pot are at or near retirement.
Such a person is actually still faced with the following two significant financial risks leading up to retirement.
Well, first. An individual has no control over what often on old.
And therefore, the rate at which one can convert a pension pot into an annuity will be a point of retirement.
And in addition to the long term decline that we can see the bond yields and graph, you can also see quite a bit of fluctuation.
In fact,
fluctuations from day to day in the bond yield can also make a significant difference to the rate at which one is able to convert one's pension pot.
Depending on what month one retires, not just ones what year.
Now, in addition to the rate at which one can convert money into one's pension pot into an annuity,
the overall size of one's pension pot at point of retirement will also, of course, make a difference to the adequacy and generosity of the annuity.
One, we'll be able to purchase that retirement. Now, how do we deal with this fact that it's really important how much money you have at retirement?
Well, in order to try to maximise the value of one's assets, a point of retirement.
Pensions pots are typically made, mainly invested in growth, assets, equities and property, which have higher expected returns than bonds.
Throughout most of the working life of a D.C. potholder.
Since, however, returns on equities and property tend to be more volatile than those of bonds, the investment.
The investments of a D.C. pension pot holder are typically sent by default on a lifecycle path of de risking.
Now that's the USS default amongst those out of growth assets and into bonds during the years leading up to retirement.
And here's the rationale for having good growth assets for, say,
the first 30 years of your working life and then for the last 10 years de risking into bonds.
The rationale is that one needs to protect against a great fall in the value of one's assets from which you won't have much time to recover.
Close to the point at which one needs to transform these assets into an annuity.
And one need to do this, even though this involves a shift in investments with lower expected monetary returns.
Historically, however, such de risking would have been typically costly and ineffective as a means of
protection against downturns in the stock markets for U.S. and U.K. workers.
And here's an illustration. In these. How big one's pension pot would have been at various dates of retirement?
After a full working career, if wanted, kept it 100 percent invested in stocks or equities, the pink line, by contrast,
indicates how big one's pension pot would've been a retirement if one had the risk out of stocks and bonds.
As one neared retirements now, as these graphs illustrate the vast majority of years from 1948 to 2007.
Even those proceeded by fairly sharp downturns in the stock market.
This sort of de risking would have made workers in the UK and the US actually poor in retirement.
Then a high wire strategy of remaining invested purely in stocks or equities throughout one's career.
Now, in comparison with the collective multiemployer defined benefit pension scheme, which was the topic of last week's lecture.
I think we should conceive and it's useful.
Steve, of the individual with his own defined contribution, pension pot as a pension scheme consisting of a single member.
So within it, most a few decades.
He's working life and his life itself will come to an end, and this is for the simple reason that the days of our lives,
the days of our years are three score years and ten, and if by reason of strength, they before score years.
Yet it is their strength. Labour and sorrow for Jews soon cut off and we fly away.
But when he retires in individuals,
one person pension fund will stop receiving any further contributions into it along lines of a DB fund of a sponsoring employer who ceases trading.
If you would like to guarantee a pension income for life,
what this individual with is one person pension scheme now needs to do is arrange for the assets of his
pension scheme to be bought out by insurance company that provides a bond back to annuity in exchange,
as described earlier, at least as one alternative. Now, as I noted,
the individual also feel the pressure to de risk from stocks to bonds during the years leading up to retirement
in order to provide protection against a great fall in the asset value before purchasing the annuity.
And so instead of the individual closing his pension scheme and having an insurance company buying it out, so to speak.
Question we. I want to ask now is might there be a more cost effective way for an individual to manage
longevity and investment risk than by means of life-cycle deed risking and purchasing an annuity?
The insurance company buyout. The answer is yes. As was the case last week and general theme,
the solution to the problem of expensive pension provision involves collectivisation into a mutual association for mutual advantage.
But unlike last weeks,
this mutual association involves individuals who retire at the same time rather than the various employers of the last man standing pension scheme.
Here's one promising. He operates.
Largely within and involves only minor modifications of the familiar structures of individual defined contribution pension pots.
So rather inexpensively give risking their portfolios to in the years leading up to retirement,
at which point they purchase an annuity whose income is pegged to the yield on bonds.
Under this solution,
individuals keep their pension pot continuously invested throughout their working lives in a portfolio heavily weighted for its growth assets.
But when an individual reaches retirement age,
he and others who retire at the same age and the same date enter into the following income drawdown, mutual arrangement with one another.
So the average life expectancy of this cohort. Map moves are the same age as Imputed.
Let's assume that's 20 years. And then these individuals hire the services of an actuary who will provide them with a
best estimate of the long term returns of their pension pots over the next 20 years.
And so the actuary also calculates how much could be withdrawn each month on the pension pots of each retired member,
such that if the expected long term returns on investments is precisely realised each year in an equal amount,
it's withdrawn from the fund each month. Then the entire park will be completely depleted after exactly 20 years.
The average life expectancy. Now, each individual would receive these equal amounts in the form of income drawn down from
the fund directly proportional to the size of his pension pot at time of retirement.
Now. We haven't yet solved the problem mentioned earlier with income drawdown,
that some individuals will live longer than the rate at which their pension pot
is drawn down and others will die before their part is completely depleted.
And it's at this point that we introduced the following vital and in fact, dramatic twist.
For anyone who dies before 20 years have elapsed,
the assets he would have received between his death and his 20th year of retirement are redistributed to
everyone else's pension pot to be drawn down by the rest of them in the event they live more than 20 years.
In the past, Debrett, that anyone who dies after 20 years have elapsed.
Has his unconsumed assets also redistributed to the pensions pots of those who live even longer?
Eventually, all the assets are redistributed, so they end up being drawn down.
You're going to and drawing down by the last person alive.
So unlike a multiemployer pension scheme such as you assess, this is literally a last man standing arrangement.
He's the last person standing arrangement. Now, the scheme I've just described is essentially a version of an arrangement known as a tontine,
which traces its origins to Europe in the 17th century,
was widespread in the 18th and 19th centuries,
and played an especially large role in providing for the retirement to people in the United States at the turn of the 20th century.
The Tontine also figures in various works of fiction involving murder plots, as we can well imagine, including this episode of The Simpsons.
Now, unlike many of the historical instances which involve the transaction with an insurance company or the government,
the version of the tontine I've just sketched takes the form of a mutual association.
In the case of ordinary individual income drawdown assets and one's pensions,
part that one wasn't hasn't consumed a death go to one's heirs or whom everyone designates in one's will.
Under this Tontine arrangement, by contrast. The assets go to everyone else in one's cohort who belongs to the mutual association in
a manner that provides insurance against the risks about living one's own pension pot.
Although I've just explained how such a tontine handles longevity risk, I've not yet explained how it handles investment risk.
And that's what I want to explain now. Given the volatility and uncertainty of returns on growth assets expected long term returns on its shores,
assets will very, very, very are very unlikely to be precisely realised.
And therefore, if one is invested in growth assets,
one runs the risk of either draw down the growth assets too quickly so that the longer the members,
the cohort that form the mutual association,
outlive them or else drawing down the assets too slowly so that some of them go to waste by remaining on the table unconsumed.
After all, members of the association die.
Now, there is a way to manage such investment risk, and it's by means of of the same sort of lifecycle de risking that I talked about earlier.
But unlike the case of such risking from a growth portfolio into a bond portfolio during the last decade of one's working life,
which is represented by the downward slope of the yellow dotted line, the downward slope is from the age of 57 to sixty seven.
Here, the de risking out of growth assets and into bonds are again only a point of retirement represented by the downward slope in the purple line.
It's assumed to be 67. And the portfolios of the cohort that forms a tontine gradually de risk.
I mean, it's a it's a more gradual Driskell less steep decline.
Members of the members took one arrives, a pure bond portfolio shared only by those who are unusually long live.
I mean, it's only when people reach the age of 90 that the portfolio is already just a few risks all the way to bonds.
Now, under an innovative arrangement along these lines that Royal Mail has proposed.
Complete de risking into a low bond portfolio takes exactly as long as plotted on the graph.
Only one his 90th birthday. An actuary for Royal Mail, Willis Towers Watson,
has estimated that such an arrangement can be expected to give rise to an average level of pensions income for people who retire now,
which would be 70 percent greater than the income they would have received if they did risk in the more traditional fashion.
From a growth portfolio into a bond portfolio during the last decade of the working
life as depicted by the yellow dotted line and purchased an annuity upon retirement.
Now the reason pension pensions, income is so much greater during retirement has entirely to do with the fact that
the portfolios of members remain entirely invested in growth assets for longer.
So it all comes down. To the difference between the yellow dotted line and the purple line,
the yellow dotted line represents returns on a pension pot for someone who does risks in
traditional life-cycle faction life-cycle fashion to purchase an annuity at retirement.
The high horizontal line at left represents expected long term returns on a growth portfolio,
which is estimated to be a bit less than four percent above the yield on long dated government bonds,
the so-called risk free rate, which is zero on the vertical axis.
Now, the initial drop in the yellow line represents the decade long de risking in the years leading up to retirement,
the further drop down to the low yellow horizontal dotted line.
Come from a guaranteed inflation linked annuity.
When benchmarked against the very yield, low yield on long dated government bonds and since its inflation protected,
its even lower than the average bond yield. And I think that it's also low because they're also selling survivor benefits.
Now, by contrast, the Purple Line represents the high returns on a growth portfolio in which scheme members are invested
until the point of retirement and then this gradual de risking descent to a pure bond pool portfolio.
By the time any scheme member reaches the age of 90. Now, the that the.
The absence of deerskin before retirement improves expected pensions income by about 15 percent in comparison with an annuity.
And this this bit, this this this gap is about a 15 percent difference.
And the returns on investment and growth assets during retirement. As compared with being in an annuity.
Improves expected income and trauma by a further 50 percent.
Now, these two improvements compound to a 70 percent or wrong approvement relative to the yellow dotted line.
Now, it's important to stress that the 70 percent improvement upon retirement income that one gets from
an annuity represents the amount of improvement one can expect on average over this guaranteed.
Annuity income. Now, depending on how returns on growth assets actually turn out relative to bonds, the amount that people end up receiving trauma,
it might be more or might be less than a 70 percent improvement on this guaranteed income from an annuity.
Now, in the case of any cohort that retards in a given year and enters into this Tontine arrangement,
the Purple Line represents the expected return on their pension pot before and deter and during retirement.
Now, especially during the period in which people invested entirely in growth assets,
the actual returns of cohorts of different ages who were time, different years, might actually vary quite a bit.
Not to reduce this variability and unpredictably unpredictability of income, which depends on data retirement.
Well, here's a solution, if one doesn't want to have such a trip to run the lottery of,
you know, well, all of my assets grow during the period before retirement, at retirement.
Different cohorts might agree in advance to smooth over the higher or lower returns on investments that cohorts enjoyed different years.
So if the returns of the pensions part of a given cohort exceeds the expected mean represented by the purple line,
those higher than expected returns will be transferred by this prior ex ante agreement to the
pensions parts of those cohorts whose returns fall short of the purple line as a result.
Of this race varying between different cohorts.
The different codes would receive an income closer to that which is implied by the purple line than they would have received of each cohort,
completely internalise all their gains and losses. With no transfer from cohorts, with good investment by luck to those with bad investment.
Luck now with the introduction of this smoothing of investment returns between
the different cohorts that are entering into these Tontine arrangements,
we've now finally arrived at a description of the workings of Royal Mail's proposed new pension scheme, CDC, or collective defined contribution.
Now, in the absence of such smoothing of returns between different cohorts,
this Tontine arrangement I described earlier is a variant of C. D. known to I.
D. c. It's called see IDC.
Which stands for collective, individual defined contribution.
Now, one of the virtues of the Royal Mail scheme that's designed so that will be possible to write generous pensions,
even on the assumption that the scheme closes to new members and slowly goes into run off as existing members retire and then die.
And the way it does so if if if Royal Mail slowly goes out of business or the scheme closes.
Is that then it would naturally, gradually transform from CDC to see IDC.
So absent the influx of new members into the scheme will eventually arrive at the last cohort of workers who retire at the same time.
In the scheme and the last cohort and those immediately preceding them will be treated pretty much a self standing tontine
arrangements along the lines that I initially described with no cross subsidy or smoothing between the different cohorts.
And therefore the scheme will eventually resolve itself into a pure version of C IDC or the Tontine arrangement I described earlier.
Now, it will be possible for these final cohorts to stand on their own bottoms, so to speak.
Given the gradual de risking of their portfolios as represented by the purple slope, which I described earlier.
Now, in the absence of smoothing between different cohorts, there will be more variability in pensions, income, depending on your retirement.
But this gradual purple de risking of each core cohort's portfolio,
combined with a redistribution mechanism from the dead to the living of the tontine,
will still render it very likely that all members of a given cohort will receive a relatively steady income until death,
which is much more generous than the guaranteed income in retirement. One could purchase in the form of an annuity from an insurance company.
No one could attempt to overcome this problem of increased variability in the income of members of different
cohorts as the scheme winds down by taking steps to ensure that the scheme remains open for the long term.
With a steady influx. Of new members, in fact,
if one could be confident that the scheme would remain open with a steady influx of new members for at least the next two or three decades,
then one wouldn't even be able to introduce this gradual de risking of the portfolios of members in retirement.
Rather, if you knew that the scheme would remain open for 20 or 30 years, one could remain indefinitely invested in a high level of growth assets,
as one would always have the option of smoothing differences and returns between
different cohorts in order to provide everyone the level of pension income,
which is implied by the expected return of at least.
Be likely to provide that.
Now, what I've just done is introduce, introduce smoothing, not just between all existing members of the scheme, as in the case of Romell,
but also between existing members and the anticipated future members of the scheme, which you anticipate will join over the next 20 or 30 years.
Now, as I shall now explain. We've actually now arrived.
By means of building up from individual defined contribution pensions, parts through the addition of different forms of risk pooling.
We've now arrived at a pension scheme, which is very much like the USS scheme that existed in nineteen ninety six.
The valuation of which was the launching point of last week's lecture.
Now, as I mentioned last week, this was a scheme funded on the basis of a best estimate of returns on a portfolio indefinitely
invested heavily in growth assets with a roughly 80 percent weighting towards equity.
Now, in comparison with the purple line of our CDC scheme.
The investment approach, if you are thrust in the 1990.
Committed by this green horizontal line. Just. Drawn in.
In 80 percent, equities portfolio is not as heavily invested in growth assets as the purple preretirement portfolio.
Royal Mail and for that reason, the green horizontal line is lower than the horizontal preretirement portion of the purple line.
But unlike the purple line, there's no de risking of the assets that corresponds to the retirement years of individual members.
And therefore, the green line never slopes downward.
The justification for this lack of de risking is that even though individuals will age and die, the scheme as a whole will remain relatively youthful.
As the average age of scheme members will remain relatively unchanged through the anticipated influx of new members to replace those retire.
And then it will always, therefore, remain possible to smooth differences in investment returns across different cohorts and plan that we
will get the expected long term be able to deliver the expected long term return through such smoothing.
There's another crucial respect in which this intergenerational CDC scheme converges on USS as it existed in 1996.
And this has to do with the level of guarantee of the defined benefit or the final salary that.
And this is a point I want to stress as I draw today's lecture to close.
Now, as the name implies, CDC is a type of defined contribution.
Now, like the more familiar, individualistic version of defined contribution,
IDC individual defined contribution risks are placed on workers rather than employers.
But with CDC, risks are borne by workers collectively rather than individually, in the manner I've been describing.
Now, as in the case of ITC, however,
the employer's obligation extends no farther than the putting of a contribution into the pension fund of a given fixed amount in a given year.
No further obligation. The CDC pension a worker ends up receiving in exchange for his country, which might be relatively generous.
Is based on a target rather than a hard promise of a given amount of pensions, income in retirement.
The CDC target consists of that pension, which you will be possible deliver if, but only if investment returns are as good as expected.
With these smoothing mechanisms. If investment returns are less good than expected and hence the targeted pension is underfunded.
There is no obligation on the part of the employer to repair the underfunding.
Director of Deficit Recovery Contributions. Rather,
the future or her pensions and income of workers adjusted downward to the point
where they can be funded out of the lower than anticipated actual returns.
Now, these cuts in pensions, Meydan hopefully will be later restored if returns on investments and exceeding expectations in later years.
Now. In 1996. The year the valuation of USS with which I began last week's lecture,
things were in fact a little different in so far as the enforceable obligations of employers to deliver pensions were concerned with c.D.
A little different from CDC insofar as the enforceability of the pensions obligations concerned.
So back in 1996. There was no legal requirement to make good.
And you underfunding of an ongoing scheme with extra deficit recovery contributions,
all these calls for deficit recovery, Confucians were not binding. In 1996, moreover, before 1997,
it was possible for an employer with a final salary scheme to freeze his liabilities
by deciding to wind up his pension scheme so long as the scheme rules permitted this.
And if the assets in the scheme were insufficient to meet the accrued liabilities,
the benefits could be reduced under the order of priority spelled out in the scheme rules.
Now. You were exposed to the original scheme rules allowed for a majority of sponsoring institutions to terminate the scheme at any time.
So long as they were basically for the scheme to be terminated any time,
so long as they secured the consent of the joint negotiating committee with
equal employer and union membership and an independent chair with casting vote.
Now, what would happen if? Employers plus the Jahns, he decided to terminate the scheme.
Well, what would happen is that the assets would, in the scheme and in the fund,
would then be distributed first to secure the pensions of pensioners who are receiving pensions and payment,
then to secure the pensions of deferred members, and finally to secure the benefits of active members with what remained.
And if the assets in the fund at the time proved insufficient to provide us as U.S. assets, quote,
promised 180 of final salary pension to a given category of scheme members, they would've been out of luck.
I don't think many people realise how soft the deeply promise was in the 90s.
Now, today, the situation both for you, assassin for pension schemes more generally is very different.
In the mid 2000s. Legislation came into force, which requires solvents,
answering employers in the UK lined up IBI scheme to secure the pensions liabilities law members, active, deferred and pensioners.
By paying a sum of money sufficient to cover the cost of purchase of annuities, which will provide the exact same pension.
So instead of being the walk away, close down the scheme, spread the assets around for as far as they go.
Now, if someone wants to leave a scheme,
they have to buy out the pensions liability so everyone receive exactly the same pension if you are wanted for a scheme while you're still solvent.
Now, as I previously noted, the cost of annuities closely tracks the yield on long dated government bonds.
And Trinity College actually had to pay that high cost in order to do the scheme while still solvent.
Now, another important difference between 1996, a pensions protection fund was created in the meantime in the mid 2000s.
The Pensions Protection Fund protects scheme members from employers who wind up their pension schemes on a get on account of insolvency
while lacking sufficient means to buy out their pensions liabilities with an insurance company or otherwise pay all pensions as they fall,
too, from the assets in the scheme. The members received compensation from the pension production fund for loss of their pension,
and the fund is financed by insurance premiums levied on all schemes which are invested in a portfolio weighted towards bonds.
And the Pension Protection Fund explains that its own portfolio with bond weighted quote,
because we need to be solvent at times when general pension schemes are significantly underfunded.
We keep the need a low risk strategy that aims to be relatively uncorrelated to the funding levels of the schemes to protect.
Now, note that these forms of protection against loss of one's promised DB pension,
which weren't around in nineteen ninety six, all involve backstops that secure pensions out of bond portfolios.
And it's for this reason that the regulator is keen to ensure that the funding of DB schemes does not fall too far
short of the cost of purchasing such a bond portfolio in the event that an employer becomes weak or insolvent.
At the same time that the returns on the assets in their DB scheme are less than expected.
The contrasting approach of the 1990s to finding DBI schemes of low contributions with
greater reliance on the higher expected returns of growth assets makes good sense,
I think. Only in the absence of the legal protections of our pensions that have arisen since the mid 90s.
So we can't return to those days of low contributions and his all the way down 20 percent.
And reliance on high returns from growth assets. We are also forgoing the bond based protections of our pensions promises that have arisen since then.
In other words, we cannot have our cake and eat it, too.
Where the cake is low contributions, combined with reliance on high expected returns on growth assets and eating it too,
is the bond underpinned legal protections of our pensions promises.
Sir Ralph Bupp. If like many.
You regard the 1960s to the 1990s as a golden age of defined benefit pension provision, and you would like to return to those days.
Then you should seek to transform today's defined benefit into a collective defined
contribution where that's likely to provide from high returns on low contributions,
but does not and cannot guarantee the generous pensions that people actually received.
But we're not guaranteed. Back in the 90s and before, the so-called golden age of defined benefit pensions was in essence, even if not a name.
An age of collective defined contribution. Right. Thanks.