With the UK’s first collective defined contribution scheme about to launch, Madalena Cain and Chintan Gandhi explain how these pension schemes can provide the lifetime incomes that savers want – with no surprise costs for employers
Collective defined contribution (CDC) pension schemes are about to transform the pensions landscape in the UK. The Royal Mail Collective Pension Plan, the UK’s first such scheme, is due to launch this year and looks set to shake up the industry.
CDC schemes allow UK employers to build pension benefits for their employees through a combination of pooling contributions and offering a target – rather than guaranteed – income for life in retirement, with employer contributions fixed in advance.
Instead of a defined contribution (DC) pot or a guaranteed defined benefit (DB) pension, savers accrue a target pension with target indexation. The actual indexation (or adjustments to target benefits) will vary over time, with annual valuations determining what adjustments are affordable after re-balancing the scheme so that the assets equal the liabilities.
The fixed contribution feature of CDC schemes will be attractive for employers and, from a savers’ perspective, the pooling of investments provides the potential for better and more stable outcomes than DC.
A CDC scheme can provide what most pension savers want in retirement: an inflation-linked income payable for life from fixed-cost DC savings, without complex financial and investment decisions having to be made along the way.
Why do we need CDC schemes in the UK?
A combination of lower-than-ever interest rates and rising life expectancy has made it increasingly difficult for savers to access an income for life in retirement. DB pension promises are proving unsustainable for many private sector employers, while DC savers are finding the cost and value of annuities unpalatable.
Our 2020 DC survey revealed that more than 60% of DC employees want an income for life in retirement, yet only 10% buy annuities. This represents a significant unmet need, and one that will only grow, given the increasing dominance of DC in the UK.
The only other way to provide a retirement income from DC savings is through income drawdown. While this gives savers the flexibility to draw an income that suits their spending needs in retirement, it requires them to make complex decisions as they try to balance the pace at which they take their money against how long they may live. The financial consequences of either over or underestimating their own life expectancy could be severe.
With CDC schemes, this situation would be avoided. The pooling of investments would hedge savers’ longevity risk and remove the need for the complex financial decisions required under income drawdown. It could also enable better retirement outcomes than purchasing an annuity under DC. Our analysis shows that outcomes could be as much as 30% higher.
CDC schemes will be large arrangements, investing over a longer time horizon than the lifespan of an individual DC saver. By investing in different types of return-seeking assets and holding them over a longer period, they have the potential to generate higher returns than savers would otherwise be able to achieve on their own in DC.
This also means that CDC pensions naturally accord with investing in the type of assets the UK government is encouraging pension funds to invest in – infrastructure, illiquids and private markets
How does CDC compare with DB and DC?
In many ways, CDC brings together some of the most attractive features of DB and DC, from both an employer’s and a saver’s perspective.
Table 1: Comparing CDC, DB and DC pensions.
How might CDC change ‘at-retirement’ options?
In 2015 the UK introduced pension freedoms, meaning DC savers no longer had to buy an annuity with their retirement savings – they now have flexibility over how they take these savings at retirement.
Savers generally have the following three flexible options at retirement:
- 100% cash – Taking benefits as a cash lump sum
- Flexible income – For example putting funds into an income drawdown vehicle, and flexibly drawing an income year-on-year
- Annuity – Purchasing an insurance company annuity to provide a guaranteed income for life.
Savers can take part of their fund as a tax-free cash sum, and can also select any combination of the three options.
DB scheme savers can also access these flexibilities by transferring their benefits to a DC arrangement before retirement. While the primary aim of CDC is to provide savers with a regular income in retirement, they will have the same right to transfer their benefits out of the scheme before retirement.
As CDC evolves in the UK, we expect to see master trusts provide a CDC pension option to sit neatly alongside the flexible options listed above.
What role will actuaries play in CDC schemes?
CDC schemes pay an income for life in retirement, so, as with DB schemes, actuaries will play a key role in their development, funding and overall governance.
Employers that are considering setting up CDC schemes will need detailed advice on their proposed designs, including how the expected build-up of benefits can be supported by the proposed contribution rate and investment strategy. Actuaries will also need to help employers understand how fair the different design options are expected to be, which will require modelling of expected outcomes for different cohorts over time.
Although CDC schemes are classified as a type of DC scheme in UK legislation, there will be a legislative requirement for CDC scheme trustees to appoint a scheme actuary, who will be expected to perform two key roles:
- Certifying viability – The actuary will need to provide advice for the trustees’ annual viability reports. The Pensions Regulator has recently published its draft CDC Code of Practice for consultation. This sets out what a scheme actuary will need to consider in certifying the viability (or soundness) of the scheme design, both at outset and on an ongoing basis. This certification will require statements that the scheme has passed some actuarial value tests and meets the legal requirements. It will also require that member communications accurately describe the annual adjustment, and the target and projected pensions.
- Annual valuations – Each year, the scheme actuary will need to determine what annual adjustment to members’ benefits is affordable in order to maintain 100% funding. The trustees will be responsible for setting the method and assumptions for these calculations, and for approving the benefit adjustment to be made. However, they will need to obtain advice from the scheme actuary on these matters. Moreover, the actuary will need to perform the valuation and provide an accompanying formal report to the trustees, documenting the decisions that have been taken. Figure 1 provides a worked example showing how a 25% asset shock might impact a typical CDC scheme, including how the annual valuation would adjust target benefit increases to restore the scheme’s funding level to 100%.
Figure 1: Worked example of a market shock in a CDC scheme.
Source: Collective DC in adverse markets, Aon (October 2020)
Note: This example is for illustrative purposes only and assumes an average scheme duration of 25 years. ‘Baseline funding’ indicates the assets supporting pensions at face value, with no allowance for increases. ‘Scope for future increases’ represents the portion of assets targeting future increases to benefits.
What can we learn from other countries?
CDC-like pension designs are common in some other countries, notably the Netherlands and Canada. UK CDC legislation has reflected learnings from overseas experiences.
In Dutch CDC schemes, the funding rules require actuarial assumptions to contain margins for prudence, and allow contributions to vary over time in response to positive or negative experience. In previous market downturns, the response was to use the prudence/risk buffers to protect pensions in payment, in conjunction with increasing contributions (including from members). Given that the contributors were younger members, this led to concerns over intergenerational fairness. There have also been some concerns that communications to members did not set the expectation that there was a chance of benefit cuts.
In contrast, the assumptions used in UK CDC scheme valuations (and also when setting transfer value and other member option terms), will be required by law to be ‘central estimates’, with no margin for caution or optimism. This is crucial in the interest of intergenerational fairness. Although a well-designed CDC scheme will seek to eliminate any bias in outcomes between different generations over time, it can never (and doesn’t seek to) eliminate the luck that will inevitably vary between different generations over time.
There will also be a focus on clear member communications, both when members are building up benefits and when they are in receipt of a CDC pension, to ensure they understand that their pensions can go up or down.
In Canadian Target Benefit Plans (TBPs), rules vary by province, which makes it difficult to draw comparisons. For example, some TBPs have been created by converting existing DB benefits without member consent. Further protections have then been mandated for these schemes, which leads to lower investment in growth assets and arguably makes them more like UK DB schemes.
In the UK, there will be greater investment flexibility, arising from pooling contributions across all members over time and not having to underwrite guaranteed pension promises. In addition, employers will not be able to convert existing DB pension promises to CDC without member consent.
What does the future look like for CDC?
The UK already has the legislation to allow CDC schemes to be set up by single employer groups. The regulations and associated guidance will come into force from August 2022.
We expect to see some large UK employers, particularly those with unionised workforces, follow the Royal Mail’s lead in establishing CDC schemes for employees.
During the next few years, successive legislation will allow groups of unconnected employers, and eventually master trusts, to provide CDC pensions. This will allow many more employers to offer CDC to their employees, through either industry-wide arrangements or master trusts (Figure 2). Master trusts will also be able to provide a decumulation-only CDC solution to sit alongside existing options at retirement.
CDC should now be an option on the table for any UK employer that is looking to review their pensions and reward strategy.
As the new CDC era dawns, it paves the way for millions of UK savers to have the option to cost-effectively buy an income for life from their DC savings.
Figure 2: Predicted expansion of CDC schemes in the UK.
Madalena Cain is associate partner at Aon.
Chintan Gandhi is partner and head of CDC at Aon.