As we discussed in a previous article, CDC membership longevity and investment risk are pooled. Consequently, members are not expected to have a choice over the investment of the scheme’s assets. Instead, the investment strategy will be set by the trustees and/or may be specified in the scheme rules.
Investing for long-term growth
In an open, established whole-life CDC scheme, the membership profile can be expected to remain broadly stable. A scheme in this position should be able to invest predominantly for long-term growth. The investment risk-sharing mechanism within CDC can ensure that even with a high growth asset allocation, the investment risk borne by older members is low (you can find out about how CDC risk-sharing works here).
If a CDC scheme can have a high allocation to growth assets and maintain this allocation over the long-term, members have higher expected benefit levels than would be achieved under alternative arrangements such as annuity purchase or DC drawdown.
Capturing illiquidity premia
The first opportunity that CDC presents is the ability to capture illiquidity premium from investing in less liquid assets. These include property, infrastructure projects and other private market opportunities. CDC taking off in the UK would create a huge opportunity for schemes to support the UK economy – for example by funding large UK infrastructure projects.
A huge opportunity for schemes to support the UK economy
There's an emerging narrative that some legacy DB schemes have regret about illiquid holdings, as they try to exit these investments following the liability-driven investment (LDI) crisis and given a desire for a buyout with an insurer. However, this would not apply to CDC, where no LDI would be employed, as liabilities can be discounted without reference to gilt yields. As CDC has no reliance on the sponsor, there's arguably less risk of CDC becoming too expensive and having to close (ignoring the risk that regulatory changes in the future do put liability with the employer).
Although the CDC scheme would have cashflow requirements, paying ongoing pension benefits from the fund to retired members, there would also be new contributions from active members. An open CDC scheme is therefore not expected to have significant net cashflow requirements.
Investing sustainably
Sustainable investing should play a key role in CDC investment strategy, due to the long-term nature of the scheme. We know that trustees and members increasingly want to ensure their investments have a positive impact on society and the environment.
CDC schemes need scale to be successful, and so are expected to have a large asset base. The sheer size of the assets means even funding large-scale infrastructure projects could be possible, with a strong tilt towards sustainability through renewable energy projects, social housing, etc. CDC schemes will also provide a blank canvas to define clear and coherent sustainability objectives and policies.
Mitigating risk
As the members collectively take on investment risk, there may be the requirement to reduce accrued target pensions in nominal terms in extreme downside scenarios. One of these scenarios could be a significant fall in the value of the scheme’s assets due to a market crash.
The pension increase in a CDC scheme is expected to be calibrated once a year – based on the value of the scheme’s assets and the value of accrued target pensions at a point in time (for example, 30 June each year).
As with a DB pension valuation, there's a risk that the position of the scheme is particularly poor at that moment in time – e.g., due to a large market crash the week before. DB schemes have some flexibility here, as they can allow for experience following the valuation date when setting the appropriate recovery plan.
There could be a place for some form of tail-risk mitigation strategy
However, the timelines for CDC valuations would be much shorter, with the pension increase awarded soon after the valuation date. Therefore, although possible, it will be less flexible to accommodate an ‘unlucky’ CDC valuation date.
There's a risk the market crashes the week before the CDC valuation, meaning the scheme must cut pensions in nominal terms to achieve balance, only for the market to rebound over the following months. The pension increase the next year would likely be positive, partially or even fully offsetting the cut the year before. Over the two-year period member benefits may be broadly unchanged. However, they will have seen significant volatility in the annual pension increase. This includes a pension cut due to the point-in-time calibration of the annual pension increase award. Is there a way to smooth this volatility through the investment strategy?
Potential solution
One potential solution is the use of a tail-risk mitigation strategy, such as equity options. This helps to protect the scheme from a significant market fall between annual valuation dates. At the extreme, the level of protection could be calibrated so that the level of assets would not fall below the threshold that would warrant a pension cut.
Some DB schemes use this approach to protect the funding level as they get towards a triennial valuation. However, these types of tail-risk strategies have a cost, and depending on the structure, the premium could have a material impact on the overall investment return. Furthermore, if the pension increase award reduces over time (due to poor investment performance or similar), there's a higher risk of a pension cut in the future as there's less buffer left. Therefore, any tail-risk mitigation strategy employed to prevent a pension cut will be more expensive at this time.
However, in the normal running of a CDC scheme, with pension increase awards at a reasonable level, there could be a place for some form of tail-risk mitigation strategy. This could help smooth out investment returns in extreme market scenarios, such as a financial crisis.
Conclusion
Depending on scheme design (especially on the degree of investment risk-sharing), CDC investment strategy considerations will differ from those of traditional DB and DC schemes. CDC schemes are likely to focus on long-term growth and sustainable investing, and may have the potential to invest meaningfully in illiquid assets. Finally, although LDI will not be a feature of CDC investment strategy, there may be a place for innovative tail-risk management strategies to help mitigate pension-cut risk.