Sharing the load in pension provision

Simon Eagle looks at developments in the provision of collective defined contribution pensions in the UK

Imagine private pension provision didn’t yet exist and society decided it was time to introduce it. Three options are put forward:  

1. Employers guarantee that a fund will pay pensions at a promised level, as long as the employer remains in business  
2. Employees are given retirement savings pots that they draw from in retirement, or use to buy insured annuities  
3. Employers pay fixed contributions into a fund to pay employees’ pensions, where the pension increase (or reduction) rate varies annually depending on the funding health of the scheme.

Under option 1, some employers might question whether they want such an unpredictable and volatile cost, or an 80-year commitment that shows on their balance sheet and which they can’t be sure to honour.

Option 2 fixes that problem but puts the investment decisions – and risk – onto each individual employee, who must also cope with drawing down through an unknown lifespan, or judge whether the security provided by an annuity is worth the price.

Option 3 fixes these problems and, through the sharing of risk, can adopt investment strategies that target higher returns than options 1 and 2, thereby being expected to lead to higher average pensions. Pension increases can be relatively stable if set as follows:  

• When a scheme is opened, there is an amount of ‘headroom’ in the contributions to fund for future pension increases; it is only if the funding health suffers very materially that the headroom could run out and pensions would be reduced.  
• It is the long-term pension increase rate (rather than this year’s pension level) that varies based on funding health.

Option 3 could well be popular.

UK pension provision and CDC

You know these options as defined benefit (DB), defined contribution (DC) and collective defined contribution (CDC) respectively. In the UK, DB has evolved over time – the DB guarantee was introduced gradually from the 1970s onwards. DC started out as additional voluntary contribution pots, but became the only option when the DB guarantee became too costly for employers.

CDC is set to become an option through the current Pension Schemes Bill, which has been delayed by Brexit and COVID-19 but is still expected to achieve Royal Assent this year, with the necessary regulations following next year. The government ran a consultation on CDC just over a year ago, where it received general support from the pensions industry and broader stakeholders.  

Under the initial regulations, employers will be able to set up CDC trusts, subject to approval from The Pensions Regulator. Employers are likely to need at least 5,000 employees for this to be cost effective.

Otherwise, in time, employers could look to a CDC master trust for easier access to CDC. These could be used either for accumulating pension or as an additional option for DC savers wanting to buy a CDC pension at retirement. However, to make this a reality, a further round of regulation will be needed – the industry will need to design how CDC master trusts will work, compete commercially, and be regulated.

What’s happening internationally?

CDC has existed elsewhere for some time, particularly in the Netherlands, Denmark and parts of Canada. These countries have all received acclaim for their pension provision systems – although bear in mind that they all use different forms of CDC to each other, and to the form of CDC that is being developed in the UK.

Dutch CDC schemes have experienced problems around the perception of fairness. Pension increase levels are set based on a prudent measure, so money is being held back from the current pensioner population. UK CDC is due to set pension increases based on best estimates of funding levels, as part of achieving fairness.

Many countries have DC as the predominant private pension provision, with lump sums being taken at retirement. That can lead to individuals running out of money in retirement, or conversely being overly cautious by holding back money and not taking a good retirement income. CDC overcomes this: as a collective scheme that pays pensions for life, it automatically pools longevity risk across the membership.

For CDC, strong governance is needed to ensure that pension increase levels are set at appropriate levels. Subject to this, there would seem to be a good case for CDC in many countries.

Simon Eagle is a senior director and UK head of CDC at Willis Towers Watson