A new kind of pension could begin to improve retirement outcomes for UK workers, once the latest piece of pensions legislation is passed. Collective Defined Contribution (CDC) schemes would merge some elements of defined benefit schemes with the basic principle of defined contribution schemes, creating a ‘hybrid scheme’ that combines employer affordability with greater security and simplicity for members.
The Pension Schemes Bill was originally announced in the Queen’s Speech of 14 October 2019, but has now formally entered the parliamentary process. CDC pension schemes are only a part of it, but one that could change the whole landscape of workplace pensions – in some cases for the better, and in some perhaps for the worse.
What is a CDC pension scheme?
Currently used in a number of countries including Canada, Denmark and The Netherlands, CDC schemes are a variation on the standard defined contribution pension scheme. Both involve a ‘money purchase’ arrangement, whereby the scheme member and the employer both pay into a pension pot that grows over time. The key difference is that, with a CDC scheme, this pot is shared between all scheme members, instead of each member saving into their own individual pot.
Primary legislation to introduce CDC schemes was first put in place in 2015, but other government business since then has delayed its completion. The 2015 Act allows for two types of CDC scheme, called ‘defined ambition’ (or DB-) and ‘defined contribution collective benefits’ (or DC+). As the name implies, DB- schemes would have something in common with defined benefit (DB) schemes, in that certain retirement benefits would be guaranteed (though not to the same extent). DC+ schemes would offer no such guarantees, but the ‘plus’ element refers to the presumed greater stability of the investment pot.
What are the advantages of a CDC pension scheme?
The main advantage claimed for CDC schemes is that the investment risk is spread across all members. This has the effect of reducing volatility (the amount by which the pot’s value fluctuates with changes in the market). A 2013 study by AON Hewitt estimated that CDC schemes (if in place) would have delivered a steady 28 per cent of salary over the past 50 years, whereas DC schemes varied between 17 per cent and 61 per cent. The maximum returns are therefore lower with CDC, but very low returns become less likely.
There is another significant upside when members near retirement. With an ordinary DC scheme, a pension saver will usually move their investments from volatile equities into more stable bonds, to guard against a sudden dip in value just before they access their pension pot. However, this also tends to reduce growth opportunities in the final few years. With CDC this moving of assets becomes unnecessary, since the shared pot is always invested for growth.
Similarly, members of ordinary DC schemes will use their pot to buy either an annuity or a drawdown product, and there is a risk that the market can fall just before they make their decision. A CDC scheme would not be vulnerable to this risk, since benefits would not depend on a single decision made at one point in time.
How would benefits be paid from a CDC pension scheme?
No CDC schemes currently exist in the UK, so how exactly they would pay out is open to conjecture. However, based on foreign examples, it’s likely that a CDC scheme would pay a regular income from the member’s retirement age, based on a ‘target amount’. The amount would not be guaranteed like an annuity, however, and might end up being less than the target amount. The payouts could also fall over time, even if some schemes attempt to increase payments to keep pace with inflation.
The aim would be for payouts to continue until the end of the member’s life, but again this might not be guaranteed with all schemes. However, the risk of running out of money is likely to be lower than when using drawdown.
It seems unlikely that a CDC scheme would offer anything comparable with drawdown (where a member can take flexible amounts from their pension pot). However, if benefits are below a certain level (e.g. if the member was only in the scheme for a short time) then some schemes may offer a lump sum instead of regular payouts.
Could a member transfer out of a CDC pension scheme?
A healthy CDC pension scheme would pay out to anyone with accrued benefits, even if that person had moved on to another employer. However, people switching jobs often want to transfer their old pension savings into their new employer’s scheme, and it’s likely that many would wish to do this with CDC schemes too. Any CDC scheme should be able to transfer accrued benefits to another scheme (CDC or even DC) without too much trouble, just as a DB pension can be transferred currently. Such transfers would however be subject to strict regulation, and would probable come with a requirement to take financial advice.
Could CDC schemes replace defined benefit pensions?
If CDC schemes become widespread in the UK, then a likely effect will be the faster decline of DB (final salary) schemes. One of the reasons the government is keen to push through the Pension Schemes Bill is the number of crises involving DB pension schemes, in particular Royal Mail. Following the dispute over the closure of its DB scheme, the Royal Mail and its union expressed a wish to move to a CDC pension scheme for its 140,000 employees. However, it cannot do so until the legislation for such schemes is in place.
All employers must now offer some form of workplace pension. CDC schemes would generally be much more attractive for employers than DB schemes, as DB schemes can place a huge burden on a company’s balance sheet, while with CDC schemes there is no such employer liability. Benefits are paid out of the scheme’s central fund, which is funded by employer and employee contributions, so even if the fund is exhausted the company’s other assets are safe. In short, a CDC scheme won’t bankrupt the company.
Many public sector jobs will probably continue to operate taxpayer-funded DB schemes. However, private sector employers would have plenty of reasons for choosing CDC schemes instead.
What are the drawbacks of CDC pension schemes?
The pros and cons of CDC schemes depend on what you compare them to – and whether you’re a member or an employer. Compared to DB schemes, for example, they’re arguably less attractive in some ways to members, as the income they offer is not guaranteed and may fall, even after payments have commenced. However, they may still have some advantages over DB schemes (see below). They are certainly more attractive for employers, since there is no chance of creating a pensions ‘black hole’ that could eat up their company.
How do CDC schemes fare when compared to standard DC schemes? For members, there is the advantage of lower investment risk and potentially more certainty over retirement income. They are also simpler to understand and do not require such high-pressure decision making at the point of retirement. Against that, there is less potential for stellar growth. As for employers, being able to offer a CDC scheme may be a good recruitment and retention tool (if perhaps not as strong a draw as a DB scheme might be).
Employers will also need to take care that their CDC schemes are set up fairly. Concerns have already been raised that younger members’ contributions could be used to pay older members’ benefits. Such fears will need to be allayed, by putting appropriate safeguards in place, if UK workers are to feel comfortable paying into such schemes.
Could CDC pensions improve on DB schemes?
There are even suggestions that CDC pensions could be more attractive for members than DB pensions, despite that lack of guarantees. DB schemes typically invest more conservatively than a CDC scheme would, precisely because they need to be able to guarantee benefits. This means that a CDC pension could potentially deliver a much higher average level of benefits for the same contribution (though this level would be variable).
Simon Eagle, a Senior Director at Willis Towers Watson, is advising Royal Mail on its forthcoming CDC pension scheme. He said, ‘From a member’s point of view, comparing CDC and DB schemes isn’t necessarily straightforward. Although DB pensions have the attraction of a guarantee from the employer, they are typically invested more cautiously in order to reduce the risk that the employer can’t afford to make good the guarantee if the investments should do poorly. So a CDC scheme would be expected to generate substantially higher pensions per £1 of contributions, in many cases twice the size or more.’
When could the UK have CDC pension schemes?
After a five-year delay, the secondary legislation for CDC schemes is finally moving through Parliament, though as yet there is no firm date for Royal Assent. The UK’s first CDC scheme will be Royal Mail’s, and this will be a fascinating case study as to how this new-style pension will be received by UK workers, and how successful these schemes can be in practice.
This article was previously published by Unbiased on 8th January 2020