Defined Contribution  

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
CPD
Approx.30min

A CDC scheme would do this by turning on its head the question it asks of its scheme actuary. Traditional defined benefit schemes ask their actuary what rate of contributions is needed to provide their member population with their promised pensions. The answer drives the employer contribution obligation.

The idea with a CDC scheme would be that the scheme asks its actuary what rate of pensions members can reasonably expect to receive given the rate of contributions promised to the scheme. The answer drives the rate at which pensions are paid. From an employer funding perspective it would remain a DC scheme.

However, its day-to-day operation would probably have more in common with a current DB scheme. In particular, rather than each member investing his own individual retirement account and then using that account to purchase an individual annuity or other retirement product, investment would – as with current defined benefit schemes – be on a collective and centrally-determined basis across the scheme membership. The emerging pensions would be provided from the funds of the scheme rather than through an individual annuity.

This poses challenges: in particular, getting people in the UK accustomed to a new form of pension arrangement where pension amounts are only targets rather than being guaranteed entitlements, and where pensions might reduce once in payment.

Looking abroad

CDC schemes are widely used in the Netherlands, Denmark and certain parts of Canada. Provided the UK learns from the experience of these countries, it might be able to offer CDC schemes in a way that works in the UK environment. 

The Dutch pension system consists of three pillars: the state pension, occupational pension schemes and individual pension products. CDC schemes fall under the second pillar of the Dutch system.

Under Dutch law, the sponsoring company and pension fund are strictly separated, with the scheme usually being administered by a third party insurance company or professional pension fund.    

In the Netherlands, pension schemes are mandatory for an entire sector or profession. More than 90 per cent of employed workers have a pension scheme with their employer. The mandatory nature of industry-wide pension schemes means it can benefit from economies of scale and efficiently manage marketing and administrative costs. Mandatory participation also allows for risk-sharing between different cohorts, reducing the likelihood of the scheme being underfunded. 

CPD
Approx.30min

Questions appear on the last page of this article.