How collective defined contribution schemes work

  • Understand how a collective defined contribution scheme could work in practice
  • Learn about the regulatory backdrop to the creation of CDC schemes in the UK
  • Grasp how CDC pensions are built up and affect a client's portfolio of assets
  • Understand how a collective defined contribution scheme could work in practice
  • Learn about the regulatory backdrop to the creation of CDC schemes in the UK
  • Grasp how CDC pensions are built up and affect a client's portfolio of assets
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CPD
Approx.30min
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CPD
Approx.30min
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CPD
Approx.30min
How collective defined contribution schemes work

The closure of defined benefit (DB) pension schemes shows no signs of slowing. Yet it is becoming increasingly apparent that traditional defined contribution (DC) – or money purchase – schemes are unlikely to fulfil members' expectations for their income in retirement.  

The government's freedom and choice agenda means DC members are no longer required to buy an insurance company annuity on retirement. However, it is hard for us to estimate our own longevity, which means flexi-access drawdown leaves us open to the risk of exhausting our funds when we are at our most vulnerable.

Given that risk, it is questionable whether income drawdown is a sustainable answer to retirement provision at an overall societal level. We need a third way – in which case collective defined contribution (CDC) schemes might be the option.

What is a CDC scheme?

At the heart of the impetus behind CDC is the idea that the UK’s current legal framework for occupational pensions is too binary, particularly once members get to retirement. An employer that wants to cap its exposure to the amount it originally agreed to contribute can only do this if it limits its offering to a traditional DC scheme, which leaves members at retirement needing to choose between an insurance company annuity or flexi-access drawdown.

The first of these is often – perhaps unfairly – perceived as expensive, but the second requires members to take a view on their own likely longevity and optimal investment strategy while in retirement. An employer that wants to give its employees access to a wage in retirement paid from a common pool rather than backed by insurance company annuities cannot do that without being subject to the full rigours of DB legislation.  

That legislation can place heavy burdens on businesses. Some businesses have been rendered unviable many years later by unforeseen changes in longevity assumptions and investment conditions unless complicated mechanisms were found to detach the pension plan from the sponsoring employer. Examples include the British Steel case and, some years back, the Uniq deficit for equity swap.

The impetus behind collective defined contribution is the idea that the UK’s current legal framework for occupational pensions is too binary

Against that background, employers have increasingly taken the view that offering their staff anything other than a typical DC pension plan is more risky than it is worth. But modelling by management consultancy Aon Hewitt and others seems to show that the individualised way in which typical DC plans work can lead to investment inefficiencies and opportunity costs and – in particular – less stable and predictable outcomes than could be produced in a collective environment.

Key points

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