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A new sort of pension is launching later this year – with it intended to give higher payouts than existing workplace pensions.
Brits currently get two main sorts of workplace pension – defined benefit (DB) and defined contribution (DC).
Old-fashioned DB pensions give a guaranteed, often very generous, payout in retirement. They have also been called ‘final salary’ pensions.
But as life expectancies rose and investment returns fell, DB pensions started to die out in favour of less generous DC ones. In fact, most workplace pensions are now DC.
But now a new type of pension is being launched, with the aim to offer better payouts in retirement than DC.
collective defined contribution (CDC) is intended as a halfway point between DB and DC.
The Mirror reports that Rebecca O’Connor, pensions expert at stockbroker Interactive Investor, said: “In theory, it’s the best of both worlds. They are DC-style schemes that give some of the benefits of the old DBs.
“They sound brilliant in theory, and I support more innovation in pensions.
“But sometimes there’s more risk of them falling down on the promises they make.”
Des Hogan, of financial firm Equiniti, said last year that CDC gives workers “the real prospect of a higher average pension in retirement than they would expect in DC pensions”.
How do CDC pensions work?
The basic idea is that a workplace sets up a CDC pension scheme that workers and their employers save into, just like DC pensions today.
The difference is that the pot of cash is then shared among all members of the scheme, rather than each employee saving an individual pot.
In theory, that collective saving means much higher returns than DC pensions – though pension firms are very shy about saying this outright in case it all goes wrong.
Pensions work by money submitted being invested and growing as it earns interest over time.
Normally pension firms have to have a limit on how much high-interest investment they have. This is because high-interest also means high risk, and this needs to be balanced out with safer investments that earn less interest.
But a pension company running a CDC pension can, in theory, pick much riskier investments.
The idea is that the huge sums invested in a CDC pension pot can overall absorb the shocks of high-risk investments dipping in value.
All workers in the pension pot share the gains made in the good times, and the losses made in the bad times, but it should balance out in favour of bigger pension pots than DC schemes.
Why are CDC pensions launching?
The government first brought in laws to allow CDCs back in 2015, but Brexit and the Covid-19 pandemic put this on ice.
CDC schemes could now become reality from August this year, as that is when employers will be able to apply to set one up.
The Pensions Regulator (TPR) has published a consultation on how these CDC schemes would work.
David Fairs, TPR’s Executive Director of Regulatory Policy, said: “CDC schemes have the potential to change the pensions landscape by offering savers and employers a viable alternative to traditional defined benefit and defined contribution schemes.
“As a regulator we welcome innovation but we remain committed to protecting savers.”
Do CDC pensions work in practice?
The short answer is that they can, and they have been launched outside the UK in countries such as Canada and the Netherlands.
In the UK, the Royal Mail and its staff have been trialling the new scheme.
Royal Mail staff put in 6% of their salaries, and the postal firm tops that up with an extra 9%.
Their scheme is 100% invested in relatively high-risk investments known as equities, or stocks and shares. This is unheard of among pension firms, which normally have around 30% invested in equities.
In addition, as workers get near retirement their pensions slow down how much they earn. This is to protect individuals from sudden falls in the value of their pension pots from being over-exposed to volatile stock markets.
The advantage of CDC pots is that there is no need for that caution, as the entire pot is invested in the same way.
In theory, that means higher payouts for Royal Mail pensioners on the CDC scheme.
What are the problems with CDC pensions?
The major risk with CDC payments is if stocks worldwide suffer long-term, major falls.
If that happens, pension values fall too. Any CDC scheme with high exposure to stock markets – which will probably be most of them – would take a big hit.
That would mean reduced pension pots for people retiring.
But even then, these CDC pensioners would be better off than those on DC schemes, according to broker Aon.
An Aon document says: “But during those periods, members in DC would probably still be worse off, given they bear all risk on their own, and their time-horizons for saving are typically much shorter than in CDC, so they have less time to recoup any falls in their savings.”
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