South Africa’s retirement system is already in the throes of change with the introduction of the Two-Pot Retirement System, but once that’s in place, regulators and others in the decision-making seats may want to consider a new option for the future – one that could bridge the gap between defined benefits (DB) systems and defined contributions (DC) systems.

The option in question is collective defined contribution (CDC), says Colin Haines, EMEA Chief Commercial Officer, Wealth Solution at Aon. It’s a system that will be introduced for the first time in the UK later this year, at the Royal Mail, and has been more than six years in the making.

To clarify all those acronyms, South Africa’s retirement system used to be a defined benefits one – where risk was shared and retirement fund members knew what their outcomes would be. The country, like many others, then moved to defined contributions, meaning risk-sharing was out and each fund member had to take care of themselves, with uncertain outcomes.

Best of both worlds?

Collective defined contribution (CDC) is something of a hybrid. Like a defined contributions (DC) plan, employees and employers contribute a fixed amount. But similar to a defined benefits (DB) plan, the contributions are paid into a collective (or pooled) fund, with the goal of providing a target retirement income for life rather than a lump sum amount at retirement, which comes with complex decisions for individual retirees.

In a CDC fund, the contributions from all participants are pooled and invested together, allowing for more flexibility in investment strategies. CDC schemes in the UK will need to target inflationary increases at the outset. However, because increases are not guaranteed, this provides a platform to take a longer-term investment approach.

This will see CDC schemes seeking more return-seeking investments over longer time horizons than those currently seen in closed DB or individual DC schemes. This is expected to provide higher pension outcomes compared to individual DC.

It is important to note that benefits can fluctuate. The actual retirement income received depends on several factors, including investment performance and the longevity of plan members. However, Aon’s research reveals that well-designed CDC schemes targeting inflationary increases at the outset would be expected to have a low likelihood of cuts in practice. So while CDC does not provide the guaranteed benefit you get with a DB plan, it aims to be more predictable than a standard DC plan, with the income lasting for life.

In a nutshell, both assets and risk are pooled, contributions are defined and the investment strategy is decided by people with the financial know-how to do so.

‘Not every individual has the ability to choose the right investment strategy or to determine how to balance the pace at which they take their retirement savings against their unknown life expectancy,’ Haines points out. ‘With CDC, the investment strategy is decided by a board of trustees, which means that employees aren’t required to become experts and make complex decisions. In addition, CDC is expected to offer on average over 30% higher outcomes in retirement compared with DC, where annuities are used to secure lifetime income.’

Groundwork required

CDC has been successfully deployed in the Netherlands for some time. Learnings from their experience have influenced the development of CDC in the UK, but Haines says South Africa isn’t quite there yet. It requires a change in legislation, for starters.

‘However, it’s a very attractive option for employers, especially those with lots of lower-paid workers, because funds are pooled, the investment risk is spread and it provides employees with the dignity of a wage in retirement with the familiarity of DC’s cost and risk stability for companies.’ This means covering different generations of workers to keep the returns sustainable over the longer term.

This will help to smooth out any ups and downs in the markets. Haines points out that CDC pensions are always expressed as annual income amounts to help employees compare their pension payouts with their employment payouts – which, in turn, helps them to understand whether they are saving enough to live on when they retire. And because it provides an income for life in retirement, CDC can also be a powerful tool to help employees retire on time, bringing workforce management and operational efficiency benefits.

CDC plans could benefit South Africa’s retirement landscape by offering the potential for higher average pension outcomes, improved retirement security, reduced risk for members, addressing coverage gaps and providing administrative efficiency.

Some groundwork also needs to be laid, apart from the legislation. ‘There would need to be agreement from stakeholders, including the financial services sector and trade unions,’ says Haines.

It certainly holds promise but will require careful planning and the design of features specific to the South African context to ensure the plan functions effectively. Public awareness and education about CDC plans – including the risk that pensions could be cut – would be crucial for ensuring member understanding and participation.

DC 1.0: Funds in South Africa

‘The improvement in outcomes delivered by CDC plans around the world is compelling,’ says Fred van der Vyver, Head of Corporate Savings and Income at Old Mutual.

‘We have a big problem in South Africa with volatile outcomes from DC funds, leading to a lack of trust in the system, poor member engagement and generally poor outcomes,’ says Van der Vyver. The current DC system is failing many South Africans. The root causes include the objectives, design and performance measurement of local DC funds, many of which are set up like typical investment platforms, focused on delivering an unknown pot of money at some point in the future.

‘While DC funds can reduce costs through economies of scale, we should ask ourselves to what extent most South African funds succeed in consistently delivering the necessary outcomes: providing a sustainable income stream for the rest of life post-retirement,’ he says.

Outcomes are currently measured with technical investment metrics such as time-weighted rate of returns over one, three, five and 10 years. Risk is measured as volatility of returns or downside risk. Funds have sophisticated cost metrics such as retirement savings cost (RSC), effective annual costs (EAC), total expense ratios (TER), total investment charge (TIC), etc.

‘While all of these metrics are important, do they really help the member form a realistic expectation of the outcomes they can expect?’ Van der Vyver asks. ‘Do they really allow decision makers to measure the extent to which they are on track to deliver the required outcomes?’’

‘The improvement in outcomes delivered by CDC plans around the world is compelling,’ says Fred van der Vyver, Head of Corporate Savings and Income at Old Mutual.

DC 2.0: CDC and the Future of South African retirement funds

‘Aon’s work in the UK has been on our radar for years,’ says Van der Vyver. ‘The clear objectives and improvement in outcomes delivered by CDC plans around the world is compelling.’

He adds that CDC funds have a clear objective aligned to what all retirement funds should aim to deliver: an adequate and sustainable income stream in retirement. Put differently, they aim to consistently deliver the targeted outcome with the highest possible likelihood. Van der Vyver believes that starting with the end in mind and backward-engineering the design is a good alternative to how many DC funds are set up and managed.

‘When we looked at the benefits of CDC systems around the world, we immediately identified many similarities between the core principles behind the success of CDC funds and our smooth bonus and with-profit annuity products in South Africa,’ he says. ‘By combining the investment risk-sharing technology of our smooth bonus portfolios and longevity risk-sharing of with-profit annuities as part of an integrated default solution to DC funds, the key benefits of CDC funds can already be delivered in our current DC system.

‘Although we do not have a regulatory framework in South Africa that allows CDC plans in their current form, we can still implement similar principles within our current DC system. At its core, what makes CDC compelling is the principle of sharing investment and longevity risk among a large group of individuals to provide more consistent outcomes.’

The main challenge facing CDC funds is the need for a large group of diverse and multi-generational members to enable effective risk-sharing. This is why the next evolution of CDC funds must be the introduction of multi-employer CDC funds.

‘South Africa already has very large commercial umbrella funds with diverse members across multiple industries and age profiles,’ Van der Vyver says. ‘Using smooth bonus funds as a default investment strategy on these umbrella funds can overcome this challenge, especially considering that the investment risk is shared within the smooth bonus fund that is also offered to other retirement funds and platforms, such as retail living annuities.’

Another challenge with CDC funds is that they offer no guarantees on the income members receive. While this is understandable (there is no employer-backed guarantee, as in a DB fund), it is very difficult for retired members to adjust their lifestyle when benefits need to be cut. Some type of guarantee on minimum-income levels will always be highly valuable to members.

‘If you integrate smooth bonus funds with the increased levels of guarantees from with-profit annuities, it is possible to offer valuable guarantees on income levels (like DB funds), without placing any funding burden on employers,’ Van der Vyver argues.

While there are concerns and criticism related to smoothing and longevity risk-sharing products, the integration of these principles is the direction in which many DC systems around the world are evolving. ‘In South Africa,’ Van der Vyver states, ‘we believe the future of DC funds will also be anchored around these principles that deliver more consistent outcomes aligned to clear objectives.’

DC 3.0: Integrated financial services

Even if DC funds succeed in consistently delivering sustainable income replacement streams for members, the final evolution required of DC funds is to allow for personalisation to meet individual members’ financial needs. ‘Some may argue that this is a bridge too far, but technology is advancing at a pace that will soon allow this,’ says Van der Vyver.

The objective should be personalised at a member level, he explains. ‘This would shift the focus from aiming to replace a certain percentage of the

member’s salary to delivering an income stream that meets everyone’s unique needs. Two members reaching retirement with the same final salary may have very different income requirements in retirement depending on, for example, whether they are renting their home or have already paid off a bond.’ The Two-Pot Retirement System is also a significant step in the right direction, recognising financial needs pre-retirement and allowing those to be met too.

‘Unlocking this DC 3.0 future requires a combination of trends coming together, including accurate, comprehensive financial data and personalised member engagement,’ Van der Vyver concludes.  ‘As an industry, we need to earn members’ trust by delivering these personalised outcomes in the most consistent way possible. We will get there, and some will get there sooner than you might think.’

* This article originally appeared in the Old Mutual Mindspace Thought Leaders Forum special issue.
Read the full publication here.