Introduction: The Issue with Risk Disclosure in CDC

Our response to the Department for Work and Pensions (DWP) consultation on Collective Defined Contribution (CDC) schemes focuses on the need for fair and transparent risk disclosure. It is crucial that the communication of CDC risks does not mislead consumers by creating ‘money illusion’, which disguises risks that Defined Benefit (DB) pension plan sponsors and financial advisers managing Defined Contribution (DC) drawdown schemes cannot hide.

While our consultation response specifically addresses communication issues, the integrity of CDC products involves broader concerns. This article explores whether CDC schemes present a genuine improvement in pension outcomes or simply shift risks in a less visible way.

Understanding the Risks of Return-Seeking Assets

CDC schemes, like all pension products that invest in equities and other return-seeking assets, face significant risks related to market fluctuations. Historically, stock markets have experienced prolonged periods of negative or low real returns, creating uncertainty for pension planning.

Our response to the DWP quantifies this risk using our proprietary financial model, which assesses the historical probability of different return scenarios over 10- and 20-year horizons. While pension professionals—particularly consulting actuaries—are well aware of these risks, CDC products do not make the risk disappear simply by pooling members’ assets.

CDC schemes are often positioned as a hybrid between DB and DC pensions, offering a collective pooling of risk while avoiding the high costs of DB schemes. However, collectivisation does not eliminate market risk—it merely redistributes it.

The History of Confidence Tricks in Pension Products

Regardless of the structure, all pension products that rely on risky assets must address a fundamental question: Can we use the risk premium of equities to reduce the cost of funding future pension liabilities?

While historical market trends suggest that equity investments deliver positive real returns over time, there are always periods where this assumption fails. To maintain confidence in such schemes, some form of "confidence trick" is often employed.

Examples of Past Pension Confidence Tricks

Several historical pension products have relied on mechanisms that concealed risks to maintain investor confidence:

1. DB Schemes Before Regulatory Changes – Employers absorbed risks without disclosing fluctuations, but international accounting rules later forced transparency.
2. With-Profits Policies – Insurers promised smoothed investment returns but ultimately ran out of reserves, exposing hidden risks.
3. Early DC Pension Schemes – Contract restrictions prevented early withdrawals, keeping members locked in despite market volatility.

All of these strategies eventually failed when transparency became unavoidable. The question is whether CDC schemes are built on a similar illusion.

How Fowler Drew Addresses Risk in Drawdown

At Fowler Drew, our approach to drawdown management acknowledges the same market risks but ensures that clients fully understand them. Our investment model is based on mean reversion, assuming that equity markets will, over time, return to an upward trajectory.

We apply this principle to planning a sustainable withdrawal rate from retirement savings, using a continuously updated return-generating engine that adjusts for:

• Market conditions and portfolio value – If markets fall, future expected returns rise, maintaining stability in long-term pension income.
• Client-defined constraints – We ensure that spending remains within tolerable limits, avoiding unexpected financial shortfalls.
• Risk management through probability-based drawdown – We do not base retirement income on a 50% probability of success (which would expose clients to an equal risk of failure). Instead, we plan based on higher confidence levels, ensuring sustainable income across different market conditions.

This method ensures that clients experience stability in real income, rather than being exposed to an unmanaged risk of forced spending reductions.

How CDC Uses Money Illusion to Conceal Risk

Unlike our approach, CDC schemes lack capital buffers to absorb investment risk. Since they do not maintain reserves, they must find another way to ensure that promised pensions do not appear to fluctuate. The chosen mechanism is money illusion—masking real-terms declines by focusing on nominal values.

The Role of Money Illusion in CDC Schemes

In traditional financial modelling, expected nominal returns consist of two elements:

1. Real returns from investments (which fluctuate based on market performance).
2. Inflation compensation (which adds to the nominal return but does not increase real purchasing power).

Historically, these two elements have contributed roughly equal amounts to nominal pension fund returns. CDC schemes exploit this structure by using inflation as a hidden risk buffer. Instead of creating a reserve fund or reducing pension payments during downturns, they simply allow inflation to erode the real value of pensions over time.

The Risks of Using Money Illusion as a Buffer

• Pension income appears stable in nominal terms but declines in real purchasing power.
• Retirees may not notice the loss of value immediately, leading to delayed financial difficulties.
• Market downturns may not cause direct pension cuts, but they prevent inflation-linked increases, reducing real incomes.

While money illusion worked in the past—particularly in eras where people were less financially aware—it has become increasingly ineffective. Today’s retirees understand inflation risks and are less likely to accept long-term declines in real income.