As Royal Mail is set to start the first UK CDC pension scheme next year, Stephanie Hawthorne asks will the arrival of these innovative plans bring pensions nirvana?
The UK pensions system is creaking at the seams, with open defined benefit schemes largely confined to the public sector while their replacement defined contribution pensions are considered to have many flaws.
Could a third way, collective defined contribution schemes — an innovative compromise — provide a more satisfactory outcome for members?
CDC schemes are no longer just the stuff of actuarial chatrooms — the first UK CDC plan from Royal Mail is scheduled to come off the starting blocks in 2022.
Terry Pullinger, deputy general secretary postal at the Communications Workers Union, is an enthusiast: “In excess of 140,000 people will go immediately into this new scheme and will enjoy dignity and security in retirement as a consequence, and we hope others will follow, because current provision of working people outside of a DB scheme is either inadequate or non-existent”.
The Pension Schemes Act 2021 introduced an authorisation and supervision regime for CDC schemes, which will help ensure that:
-Only schemes that are well run and built on sound foundations are allowed to operate;
-Schemes must have a clear strategy and resources to deal with any problems that may arise;
-Schemes must have an effective framework for communicating with members
-The interests of members continue to be protected throughout the life of the scheme;
-The Pensions Regulator has appropriate powers to intervene when necessary.
-More recently, in July the Department for Work and Pensions issued a consultation to pave the way for precise regulations.
In the foreword to the consultation, the minister for pensions and financial inclusion, Guy Opperman, says he is looking to carry out “extensive multi-employer engagement” over autumn/winter, with multi-employer and/or master trust-specific regulations then possible next year.
The biggest cheerleaders for CDC are two leading actuarial companies, Willis Towers Watson and Aon, although the Royal Society of Arts, the Pensions Policy Institute and the Trades Union Congress are among other supporters.
Shriti Jadav, CDC director at Willis Towers Watson, points to the “interest from a number of organisations in the UK looking to consider the feasibility of CDC for their employees”.
“At the moment, conversations have largely been with those in the utilities or industrials sector who wish to provide employees with a regular income in retirement, but at a fixed cost for the employer,” she says.
Based on cost estimates and scheme size projections, 10,000 active members are thought to be enough for a CDC to be well run and operate self-sufficiently within the constraints of the charge cap.
However, Jadav says: “For CDC to really take off in the UK, we believe multi-employer and/or master trust CDC schemes will be required, so that costs can be spread over a larger membership base.”
Defining CDC
Currently, there is no standard definition of CDC. Kevin Wesbroom, professional trustee at Capital Cranfield, notes that this “is part of the problem when discussing CDC”.
He adds: “It means different things in different parts of the world — Holland, New Brunswick (Canada) and Scandinavia. The key differences about the UK are that we are not proposing to change past benefits — this is all about new benefits. And we have built our system of the errors of others.”
A CDC scheme pools members’ assets and aims to pay out a target retirement income from those assets. There are differences in scheme design around this fundamental principle, including whether or not to operate a capital ‘buffer’ to provide stability of retirement income.
CDC lies somewhere in between DB, where the end benefits to members are defined but costs of provision are uncertain and the employer covers the costs, and DC, where end benefits to members are uncertain but costs of provision are defined.
There is sharing of risks and related returns among members of the CDC arrangement, hence the ‘collective’ tag, and possibly the employer too. A CDC scheme instead has a target or “ambition” amount it will pay out, based on a long-term, mixed-risk investment plan.
“For CDC to really take off in the UK, we believe multi-employer and/or master trust CDC schemes will be required, so that costs can be spread over a larger membership base”
SHRITI JADAV, WILLIS TOWERS WATSON
CDC schemes aim to pay out an adequate level of index-linked pension for life but this is an ambition rather than a contractual guarantee. They have the scope to redefine the benefits they offer if circumstances — such as adverse economic conditions — require.
More simply, the basic principle is that it is a DC scheme with an extra level of guarantee and some element of risk-sharing between members and/or employers.
In the proposed Royal Mail CDC scheme, each member builds up pension at the same rate (1/80th of pay for each year of service). In a given year, every pre-retiree and retired member receives the same pension adjustment (usually an increase). This reflects the best estimate of the increase that the scheme’s assets are sufficient to provide every year in the future.
A Willis Towers Watson case study in 2019 showed that if the Royal Mail CDC scheme had been opened in 1925, there would have been only two years in which the face value of pensions were reduced (due to asset volatility), the last one being way back in 1933.
Furthermore, in October 2020, the same company stated for a given level of contributions, typical CDC pensions would be expected to average 70 per cent higher than either individual DC insured annuities, or 40 per cent higher than pensions provided on average in DB schemes. This boost arises from differences in investment strategy between the scheme designs.
Yet there is a downside, following the 2008 financial crisis the Dutch reduced CDC pensions by 2 per cent on average.
David Pitt-Watson, leader of the Tomorrow’s Investor project at the RSA, notes: “That was what was needed in order to get things balanced again and to make sure you did not have an intergenerational transfer.”
These benefit cuts have priority for restoration. By contrast, in the UK, the cost of buying an annuity increased by 29 per cent over the three years 2009-12 — a permanent reduction of nearly a third.
Advantages of CDC
-Fixed costs for employers and employees. Employers will not have to pay shortfall contributions (as they do in a defined benefit scheme), unless guarantees are provided.
-Higher expected investment returns: The sharing/spreading of experience in collective defined contribution means that target investment returns can be higher than in nearly all DB/DC arrangements, and so, for a given contribution rate, the level of pension is expected to be materially higher.
-Smoothing of returns: volatility is smoothed out so that member pension levels (both pre and post-retirement) are relatively stable.
-Risk of running out of money is averted unlike a drawdown pot
-It is simpler for members than DC as they do not need to make investment or retirement provision decisions.
-Sharing of longevity risk members are able to get protection from longevity risk without having to use the insurance market (which can be costly).
-Simple pensions accounting. Employers will only account for contributions made to the CDC scheme (unless guarantees are added to the design)
-No P&L or balance sheet volatility. At present, accounting for DB pension obligations leads to volatile balance sheets and profit and loss accounts. ---DB pensions can turn a profitable company into an unprofitable one and this is removed with CDC.
Disadvantages of CDC
-Complexity may not be appreciated by staff as the complexity of CDC will need outstanding communications.
-Governance. Organisations will need to appoint advisers, actuaries’ trustees, etc, to manage the CDC scheme.
-Member expectations. CDC schemes will be required to provide members with a projection of their expected future retirement benefits, which will set members’ reasonable expectations. If members plan their retirement based on these projections, and if the actual income received is significantly less, members will have little time to adjust their retirement plans.
-Uncertain retirement income. Members will have no certainty over retirement income and, unless guarantees are provided, may end up with a far lower income than expected. Further, income may fall in retirement if asset returns are poor. It will then be very difficult for members to rectify this situation (ie, they may no longer be able to work).
-Loss of control. CDC schemes may restrict members from accessing their pension savings flexibly for the reason of maximising investment returns (if funds are being withdrawn by members, for example, through freedom and choice, it will be harder for the CDC scheme to generate the returns required to meet the expected pension income).
-Intergenerational fairness.
-Mission creep — as with DB legislation, CDC schemes may eventually impose onerous guarantees on employers and pension providers.
Intergenerational fairness is a key risk
The key risk to members of a CDC scheme is one of intergenerational fairness. That is, the first cohort of members in receipt of a pension may receive more (or less) than subsequent generations.
Some critics have likened CDC to a Ponzi scheme. The stability of these type of pension funds depend on a regular stream of new entrants (and contributions) to generate the investment returns required to provide the expected retirement income.
The volatility of investment returns also contributes to this. During periods of strong returns, pension payouts may be high, while payouts may fall during times of poor returns.
As Tom Selby, head of retirement policy at AJ Bell, points out: “Making sure members understand how they work and the associated risks, including the possibility their pensions will be cut in the future, will be vital. Simply referring disgruntled members to a complex set of scheme rules they signed up to blindly years ago won’t be good enough.”
In practice, actuaries will try to smooth out such peaks and troughs, but try as they might, critics state it will be impossible to distribute cash from a CDC scheme without creating winners and losers.
If members live longer than expected, this will also create an intergenerational cross-subsidy, as the cost of paying pensions for longer would be met by the working population.
Penny Cogher, partner at Irwin Mitchell, explains that “mortality pooling is the main selling point of a CDC scheme over a traditional DC scheme”.
“Master trusts are able to provide a mass market product covering far larger populations than schemes set up just for a single corporate group,” she says.
Cogher notes that if mortality pooling is added to all the other advantages of master trusts, “the case is compelling”.
She adds: “Master trusts already have experience of complying with an authorisation and supervision regime run by TPR. They already have effective governance systems and investment, communication and administration expertise. Master trusts just need to add the required actuarial expertise to their armoury in order to offer CDC.”
“If the UK is serious about improving its workplace pension provision, the adoption of CDC is hugely important”
TIM MIDDLETON, PENSIONS MANAGEMENT INSTITUTE
Tim Middleton, director of policy and external affairs at the Pensions Management Institute, says: “CDC lies at the heart of the pension systems operated by the Netherlands and Denmark. As these two countries consistently top the Mercer CFA Institute rankings, CDC has impeccable credentials — it is both tried and tested and highly successful.
“If the UK is serious about improving its workplace pension provision, the adoption of CDC is hugely important.”
Wesbroom adds: “The immediate challenge of CDC is to get the Royal Mail scheme over the line. But the bigger opportunity and challenge is to develop post retirement solutions for CDC incomes.
“As an industry we have failed to respond to freedom and choice in 2015. We have not come up with a simple alternative to an annuity — for a DC member to convert their savings into an income that will live as long as they do. CDC offers that solution.”