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Article | Pensions Briefing

CDC pensions – ready to navigate turbulent times

By Simon Eagle , Shriti Jadav and Edd Collins | November 23, 2022

The introduction of Collective Defined Contribution (CDC) pension schemes in the UK is now a reality, with the Royal Mail scheme expected to open to accrual early next year. So what are CDC pensions, how do they deliver better retirement outcomes, and how would they compare against other forms of pension provision in turbulent market conditions?
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Why is there interest in CDC?

Royal Mail and the Communication Workers Union jointly engaged with Government in 2018 to enable the introduction of Collective Defined Contribution (CDC) pension schemes in the UK. The objective was to enable an alternative to existing defined benefit (DB) and defined contribution (DC) pension schemes, and seek to:

  1. Provide employees with a pension in the true sense – an annual income in retirement
  2. To fix costs for the employer
  3. To ultimately deliver higher pensions than could be provided within the existing pensions regulatory framework.

With the legislation required to establish CDC schemes completed earlier in 2022, and TPR having set out how it intends to authorise these schemes in its Code of Practice, we expect to see the Royal Mail CDC scheme open to accrual early next year. Moving beyond Royal Mail, the Government has plans to further extend the legislation to allow different types of CDC schemes to be set up, including multi-employer CDC schemes and CDC master trusts, with the first consultation on this expected later this year.

Our 2020 guide to CDC, provides an in-depth look at CDC. In light of the renewed interest in CDC, this article serves as a reminder of the key points and provides an update on some subsequent developments.

What is CDC?

While CDC schemes share some similarities with individual DC schemes in that contributions are at a fixed rate, their collective nature means there are some key differences.

  • Firstly, contributions are paid into a collective pool of assets, so individual members do not have their own pot of money as they do in an individual DC scheme.
  • Secondly, these assets are invested with an aim to generate relatively high investment returns over the long-term, with the pooled nature allowing the scheme to take more risk than an individual member may be able to, particularly in decumulation.
  • Finally, members will be paid an income in retirement for the rest of their lifetime. This income would typically be expected to increase in retirement, although the income could go up by more or less than anticipated or in extreme circumstances even go down during their retirement.
Overview of Collective Defined Contribution pensions
An overview of Collective Defined Contribution pensions

How do CDC schemes deliver better retirement outcomes and how would they compare against other forms of provision?

There are three key advantages of CDC schemes relative to existing provision through DB or DC schemes:

  1. Contributions are fixed, making CDC more sustainable. The contributions that employees and employers pay are fixed at outset, as they would be in an individual DC scheme. Further, there is no recourse back to the employer for any additional contributions in the future should things not turn out as expected – and this is enshrined within the legislation that enables CDC schemes and makes clear that they are a form of DC pension provision. This should give employers significant comfort that they won’t be on the hook to provide additional support to the scheme in the future. This is different from a DB scheme where the costs vary according to the funding level of the scheme.
  2. CDC schemes are expected to deliver significantly higher levels of pension for a given contribution, increasing pensions adequacy in these times of cost pressures on companies and individuals. CDC schemes do not provide any underlying guarantees, unlike the guaranteed benefit formulae in DB schemes and insured annuities bought by DC scheme members. The need to support guarantees encourages DB schemes and insurers to adopt low-risk investment strategies to support these pensions, pushing up the cost of providing them, unless the employer covenant is extremely strong (and potentially even in those circumstances under the proposed new DB funding regulations).

    A CDC scheme on the other hand can adopt a higher-risk investment strategy. For the same level of cost, it can therefore provide a significantly higher pension – modelling that we carried out in 2020 based on the Royal Mail scheme design suggested that for a fixed cost, the expected pension provided from a CDC scheme would typically be 40% higher than a DB environment and 70% higher than with a DC insured annuity (see our CDC guide and supporting analysis for further details).

    Since 2020, insured annuities have become cheaper due to increasing bond yields. However, a CDC scheme would still be expected to provide a higher pension level – noting that the choice here is between a guaranteed level of pension (from an annuity) versus a higher expected CDC pension that will vary each year, and growth assets would usually be expected to return more than bonds, to reward investors for the extra risk being taken.
  3. CDC schemes provide an income for life in retirement. Members who retire in a CDC scheme benefit from knowing that the scheme will provide them with an income for life. In comparison, DC members opting for income drawdown need to carefully manage their spending – trying to avoid running out of money before they die but not being so prudent that they take a much lower income than their pension pot might have supported.
Comparison with other forms of pension provision
  Fixed cost Higher expected pension Income for life
DB No No Yes
DC – annuity Yes No Yes
DC – drawdown Yes Yes No
CDC Yes Yes Yes

CDC of course does not come without its challenges. The key challenges arise from the fact that the pension increases are variable – so that you could have higher increases, or lower increases, or maybe even a pension cut in any year. This can be mitigated by the design of the scheme - making sure that the expected pension increases are relatively stable, as well as distributed fairly across the generations and that there is a limited risk of pension reductions. Members must understand the nature of their benefit, how it works and that the benefit is not guaranteed. They must also be able to trust the scheme, that increases are awarded in line with the design and in a transparent manner and the increase they receive is appropriate. Therefore, great communication and governance would be vital to a CDC scheme, and indeed much of this is required through the Regulations that came into force in August this year.

How would CDC cope in the face of current turbulent market conditions?

Much of the turmoil in the market recently has highlighted the challenges faced by DB pension schemes that have adopted highly leveraged LDI strategies to manage the risks associated with providing guaranteed benefits. An LDI strategy would not be suitable for CDC schemes - CDC does not offer guarantees and so does not need to match cashflows with gilts or bonds - so would not be subject to the same pressures some DB schemes have faced in light of the rapid changes in gilt yields recently.

Additionally, in the current high inflation environment, a DB pension would typically have pension increases that are ‘capped’ in payment – CDC pensions are uncapped and therefore we would expect a higher pension increase to be paid out under current market conditions.

On the DC side, we noted earlier that annuities are looking better value than they have in recent history. However, we assess that a CDC scheme would still be expected to provide a higher pension level than provided by typical current annuity rates.

Considering income drawdown, recent falls in asset values will have made income drawdown less attractive because the overall size of pots will have fallen, and so individuals withdrawing a fixed percentage each year will see a fall in income just as inflationary pressures are increasing their spending needs. The trustees of a CDC scheme would typically take a longer-term view, and spread experience through pension increases, thus resulting in a smoother retirement income. An individual in drawdown would also likely need to hold back some of their pot against their uncertain future life expectancy. As a CDC scheme can pool this individual risk across many members, they can take a broader view and provide a higher ongoing level of income to each individual.

With a range of pressures currently facing pension schemes and their members, including rising costs and increased uncertainty about the future economic outlook, we believe CDC schemes will provide a compelling alternative to existing DB and DC schemes, allowing lower costs for companies and/or higher benefits for individuals, for the benefit of society as a whole. In time, we expect CDC provision to grow to have a significant presence in UK pensions.

If you would like to discuss any of these points, please contact your WTW consultant or one of our CDC specialists listed below.

Authors

Edd Collins
Senior Director, Retirement
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Simon Eagle
GB Head of CDC Consulting

Shriti Jadav
Director - CDC Consulting

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