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.
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.
- Collective defined contribution (CDC) schemes might be an alternative to defined benefit schemes
- In a CDC scheme, the actuary is asked what rate of pensions members can reasonably expect to receive
- CDC schemes are widely used in the Netherlands, Denmark and certain parts of Canada
Furthermore, at a collective level trustees acting on behalf of members can have access to investment and actuarial advice and opportunities that would not be available in a cost effective form to individual members acting on their own behalf.
Squaring the circle
CDC is an attempt to square that circle. It offers members access to the benefits of a trust structure where fiduciaries act on their behalf in taking investment decisions and working out the rate at which pensions for life can be paid from the trust assets on the basis of pooled investment and mortality risk. At the same time it makes it clear that employers are responsible only for paying their agreed rate of contributions and are not exposing their business to the future risk of unexpected deficit repair obligations if the assumptions used to calculate the benefits provided from the plan turn out to have been over-optimistic.