There are two main options available at retirement at the moment for DC savers – annuities and income drawdown. Annuities provide a guaranteed income for life – the traditional route of pension provision for a DC saver. However, due to their guaranteed nature, the level of pension they provide is necessarily relatively low. Annuity levels increased in 2022 due to bond yield rises, but other arrangements that seek returns well above bonds would also have seen increases in income levels.
The current alternative to annuities is income drawdown. Income drawdown has appeal as it allows people to seek higher returns (by leaving their money invested in riskier assets without the need to provide for a guarantee), access their money flexibly and potentially pass on assets to the next generation. But its big flaw is that it needs the individual to decide on the pace of income, based on their own assessment of their individual lifespan which is virtually impossible to forecast with any accuracy. Also, it requires the individual to manage their own assets on an ongoing basis which can be too much of a burden, particularly once past a certain age.
In our previous article, CDC pensions – ready to navigate turbulent times, we noted that we believe the case for introducing CDC pensions is a strong one. The previous Pensions Minister, Guy Opperman, also stated his belief that ultimately the introduction of CDC pensions in the UK will deliver better retirement outcomes for millions of pension savers1. With the current squeeze on personal finances being felt up and down the country, that can only be a good thing.
Ultimately the introduction of CDC pensions in the UK will deliver better retirement outcomes for millions of pension savers.”Guy Opperman MP | Former Pensions Minister
CDC pensions solve many of the problems inherent with current DB and DC pension scheme designs – employer contributions are fixed and manageable, the scheme pays members an income for life in retirement and, for a given level of contribution, expected retirement incomes are higher than typical DB or DC outcomes. Consequently, this improves sustainability and adequacy of the arrangement.
However, the current CDC legislation is heavily prescriptive around the design and operation of a CDC scheme, and only permits single-employer schemes. This allows CDC pensions to be introduced for large employers (like Royal Mail) who wish to open their own scheme with a similar CDC scheme design. However, it precludes the availability of CDC pensions to anyone not working for a large employer, or for a large employer that doesn’t wish to set up its own CDC scheme.
To resolve that issue, DWP are planning to consult on other possible forms of CDC early this year – including multi-employer schemes, master trusts and decumulation-only CDC. As well as providing an alternative to existing pension arrangements, we believe the advent of decumulation-only CDC solutions could also be a useful addition to the existing DC pension landscape. Our polling data2 shows that 93% of those polled believe a decumulation CDC option would be of interest to DC retirees.
Decumulation-only CDC is similar in some ways to annuity purchase – you would use your DC pot to buy a CDC pension at retirement, perhaps with some choice around the level of target increases and whether you want the income to continue to be paid to a partner after you die, and in return, you would be paid an income for life. The key difference to an annuity is that the income provided would be variable, depending on underlying investment performance and the combined demographic experience across all members.
This form of CDC would address some of the key shortcomings of the alternatives – it provides an income for life so that individuals don’t have to worry about exhausting their retirement savings or making complex decisions in retirement as they do with income drawdown, and it provides a higher expected level of income than could be provided through an annuity.
However, that’s not to say decumulation-only CDC is a panacea. There are aspects of both annuities and drawdown that will be attractive to different individuals – many retirees will value the flexibility of being able to access money from their drawdown pot whenever they choose, and some individuals will be very concerned about fluctuations in their income.
For many individuals, CDC could be one piece of the jigsaw. An ideal scenario could be for a member to have easy access at retirement to all the options so that they could pick the combination of products that is right for them. For example, that might be a tax-free cash lump sum for immediate spending needs, some money in drawdown to give them flexibility and allow them to top up their retirement income over the medium term as they either need or want, and also a level of regular income to meet regular needs over retired life – which going forward could be delivered through CDC, an annuity or even a combination of the two. Similar to the way individuals diversify their assets when building up their pension pot before retirement, they could also diversify their approach to delivering an income in retirement.
Extending this further, even more flexibility could be introduced – rather than a single decision at the point of retirement, it could be possible for an individual to move between the different options. For example, initially an individual could use their pot to buy a level of CDC income at retirement with the remainder in drawdown to access flexibly. Then, later in retirement when they have greater certainty over their income needs, they may choose to purchase more CDC pension using their remaining drawdown funds.
So, what three key developments are needed to bring CDC-decumulation to life?
The current regulations were largely intended to facilitate the introduction of the Royal Mail scheme and to allow the Government and the pensions industry to better develop their understanding of CDC pensions before broadening out the CDC concept more widely. The Government is now working on extending the legislation to allow a far broader spectrum of CDC pension schemes to be set up and is engaging with the industry with a view to consulting more formally on its plans early this year. The regulations need to be extended to facilitate commercial master trusts and decumulation vehicles, and ideally also to remove various constraints within the existing regulations to give flexibility for the industry to develop innovative new designs that will work for decumulation.
When you look at buying car insurance, say, there are comparison websites that help make picking a provider easy. In the same way, individuals who would not fully understand pension products, need to be able to easily compare different CDC options and make informed choices. For example, if you were offered the choice between two different CDC vehicles, one of which will provide you with a pension of £10,000 a year and the other providing £8,000 a year, without any further detail you’re probably going to select the £10,000 option. However, underlying that might be a riskier asset strategy, with a higher risk of income cuts than the £8,000 option – and more risk than the individual is willing to be exposed to. Or alternatively, it might be the case that both have exactly the same investment strategy, but one is making more optimistic assumptions about future returns. However, it might be difficult for individuals to assess this without a common way of comparing different vehicles. Good communication with retirees and some form of consistent way to make comparisons between products will be key to enable retirees to make informed decisions.
Finally, the pensions industry will need to bring ideas, develop solutions, engage with DWP and work to make CDC as good as it can be. We all need to play our part to ensure that CDC doesn’t remain a just a great idea in theory but is really brought to life and made into a reality for everyone. We’re seeking to play a part in this and hope others will join us in doing so – we look forward to working with people across the industry to help really cement CDC as a third option for pension provision in the UK.
If you would like to discuss any of these points, please contact your WTW consultant or one of our CDC specialists listed below.
1. More savers to benefit from new pension provision
2. Polling conducted at the WTW Pensions and Savings Conference held on 1 December 2022