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Hybrids are often a way to get the best of both worlds and collective defined contribution schemes (CDCs) are no exception.
They were introduced by the Pension Schemes Act 2021, combining elements of defined benefit (DB) pensions with aspects of defined contribution (DC) schemes to offer a middle path that has been described as a ‘third way’ or ‘halfway house’.
Firms that have moved to DC have already solved their DB pension problem
No CDC schemes have yet been authorised in the UK but Royal Mail is on course to provide the first. The single-employer CDC legislation we have now was passed essentially to enable Royal Mail to proceed with the scheme it had designed with the Communication Workers Union in response to its DB scheme closure.
So, given the legislation emerged in response to a specific set of circumstances, are CDCs likely to remain a niche market? Or could they have wider appeal?
Perfect blend?
It is unfortunate that the features that make DB schemes attractive have also led to their decline. Retiring with a guaranteed income for life based on salary and length of service is great for employees but is expensive — and unsustainable — for many employers.
DC schemes are more affordable because they do not pay a guaranteed amount and employers have no liability to provide a specific level of income for employees.
The responsibility — and risk — is placed on the individual so, if contributions are not high enough to generate much of a return and/or investment performance is poor, running out of money in retirement is possible.
“Over recent decades you could argue that workplace pensions have swung from one extreme to the other,” says LCP partner and former pensions minister Steve Webb.
Larger employers could find multi-employer CDC an attractive way to differentiate their benefit offering to employees
“From a world of DB pensions, where all the investment risk, inflation risk and longevity risk were on the employer, to a world of DC pensions, where the individual has to bear all of these risks, especially in a world of pension freedoms.
“A retiree with a DC pot now has to live with the ups and downs of markets, the risk of inflation eroding their pot and the ‘risk’ of living much longer than expected. Their DB counterpart has none of these worries.”
As a hybrid of DC and DB, CDCs pay a target income for life.
Webb adds: “CDC offers greater certainty than pure DC as there is still a ‘target’ level of pension but there is some flex if markets turn down; for example, pension increases in retirement may get less inflation protection, or future target pensions can be reduced.”
Although this target is not guaranteed, it is expected to be higher than income paid by a standard annuity under a traditional DC arrangement, for several reasons.
I see challenges in accumulation, but the area of most interest is decumulation-only CDCs
The pooling of assets makes it possible to benefit from lower costs due to economies of scale. Pooling longevity risk in having members of different ages also enables growth assets, such as equities, to be held for longer, with no need to adopt strategies that move out of riskier assets as retirement gets closer.
Stuart Lewis, founder of Rest Less, a digital community for the over-50s, says: “Scheme members will be able to save into the pension scheme, then take their benefits from the same scheme, avoiding the need to make complex retirement planning decisions such as investment choice during the accumulation phase, or on-retirement income strategies at the decumulation stage.”
So far so good. Aon says it is already working with a number of employers that are looking at designs for CDCs.
There’s no reason why you should have to work for the Royal Mail to benefit from CDC
“One of the valuable aspects for employers is it presents a golden opportunity to harmonise pensions across employees,” says the head of Aon’s specialist CDC team, Chintan Gandhi.
“Where there is DB for one group and DC for another, everyone will have an option for income for life.”
Limited appeal?
Being able to provide a target income for life on a similar financial basis to that of a DC scheme, without the variable cost of funding a DB scheme, is attractive to employers.
Gandhi refers to the advantages of CDCs as “the three E’s”: efficiency in delivering returns over 30% higher than DC on average; an employer proposition to attract and retain talent; and fitting well with ESG strategies because of CDC’s longer-term investment horizons.
However, while acknowledging the advantages, most industry commentators believe single-employer CDCs will remain a niche because firms are unlikely to move from existing DC schemes.
The Department for Work & Pensions has shown some interest in this, but its first priority is the multi-employer model
“Currently, CDC is a way forward for employers that want to close their DB scheme and move to DC,” says NOW: Pensions head of DC design Stefan Lundbergh.
“Employers that have moved to DC have already solved their DB pension problem. I don’t see any incentives for them to move to a CDC solution.
“Currently, CDC has one legal advantage compared to DC: the ability to pool individual longevity.”
Standard Life managing director for individual retirement solutions Claire Altman envisages a market among large employers facing similar issues to Royal Mail, with the resources to assess suitability and a big enough workforce to make the investment approach succeed.
“But employers have invested heavily in establishing DC pensions and the benefits of the auto-enrolment system are apparent, so there is a long way to go before CDC becomes a viable option for most employers,” she says.
Opening up the market
It is widely felt there is greater potential in multi-employer and decumulation CDCs, which will require additional legislation.
For employers is it presents a golden opportunity to harmonise pensions across employees
“There’s no reason why you should have to work for the Royal Mail to benefit from CDC. We know that a number of people are looking at the potential for offering industry-wide or other multi-employer types of CDC in future,” says Webb.
Aegon pensions director Steven Cameron thinks multi-employer CDCs would open the market to different-sized employers, but he can see challenges ahead with the standard approach to benefits and limited options of the current version of CDC.
“A lot of things will be specific and fixed to cater for their members,” he says. “Will a multi-employer CDC take a fixed approach, or will it have flexibility at employer level to set the fund it invests in, or the retirement age?”
Other commentators regard intergenerational fairness as a more general problem with CDC. But Cameron envisages specific problems for pooling longevity risk in multi-employer CDCs, where employers are in different industries and different parts of the country, because the life expectancy of their employees could dramatically differ.
Over recent decades, workplace pensions have swung from one extreme to the other
“I see challenges in accumulation, but the area of most interest is decumulation-only CDCs,” he says. “But they need to be multi-employer, otherwise you wouldn’t get the scale to make it work.”
For Webb, if people do not want to buy an annuity but like the idea of some longevity pooling, he can imagine Nest or others producing a large-scale retirement-only scheme.
“The Department for Work & Pensions has shown some interest in this, but its first priority is the multi-employer model,” he says.
Others believe decumulation CDCs could become a key element of large DC arrangements to provide a default income for life.
Where there is DB for one group and DC for another, everyone will have an option for income for life
“While DC will probably remain dominant for small and medium-sized employers, larger employers could find multi-employer CDC an attractive way to differentiate their benefit offering to employees,” says Iain McLellan, head of research and development at pensions advisory firm Isio.
He thinks the government may need to set up the first multi-employer CDC arrangement — for example, via Nest — to act as a safety net dealing with other arrangements that can’t reach scale as the market develops.
