Final salary pensions are now a rarity, with most employers opting for defined contribution schemes where the employee takes all the risk of poor stock market performance. But there may be another way. Stephanie Hawthorne investigates.
Defined benefit pension schemes continue to fall out of favour for employers, while their replacement, defined contribution schemes, remain an inadequate alternative for many employees and their representatives.
But a compromise could be the CDC pension – or collective defined contribution scheme, also known as “Dutch style” (because they’re popular in the Netherlands) or “defined ambition” schemes. Until recently there was not much impetus from Government or the private sector to push through the new legislation that would be required to bring these schemes into effect.
I think CDC gives us a much better outcome for people than a traditional DC scheme. It removes the individual risk that people get in the build-up to retirement – it pools that risk. It reduces the risk of them being big losers when it comes to retirement, so it gives them a better outcome” – Jon Millidge, Royal Mail
However, with a deal finally hammered out between Royal Mail and the CWU in February, after major negotiations over employment conditions and benefits to avert strike action last year, collective defined contribution (CDC) pension schemes in the UK are now more of a real possibility, with the Royal Mail keen to replace its defined benefit (DB) scheme with a CDC alternative.
What is CDC?
Currently, there is no clear definition of CDC. “If you ask 10 people, you’re likely to get 11 different answers” says Ralph Frank, head of defined contribution at Cardano.
In general, CDC is considered to lie somewhere in between DB (where the end benefits to members are defined but costs of provision are uncertain and the employer covers the costs; and defined contribution –or DC – where end benefits to members are uncertain but costs of provision are defined).
There is sharing of risks and related returns among members of the CDC arrangement, hence the “collective” tag, and possibly the employer too.
A CDC scheme instead has a target or “ambition” amount it will pay out, based on a long-term, mixed-risk investment plan.
CDCs aim to pay out an adequate level of index-linked pension for life but this is an ambition rather than a contractual guarantee. They have the scope to redefine the benefits they offer if circumstances – such as adverse economic conditions – require.
CDC pensions for employers
- Certainty over contributions. Employers will not have to pay shortfall contributions (as they do in a DB scheme), unless guarantees are provided.
- Simple pensions accounting. Employers will only account for contributions made to the CDC scheme (unless guarantees are added to the design)
- No P&L or balance sheet volatility. At present, accounting for DB pension obligations leads to volatile balance sheets and profit & loss accounts. DB pensions can turn a profitable company into an unprofitable one and this is removed with CDC.
- May not be appreciated by staff. In particular those staff who have accrued defined benefit provision during their working lives.
- Governance and monitoring requirements (costs). Organisations will need to appoint advisers, trustees etc. to manage the CDC scheme.
Source: Steven Scott, actuary,
Xafinity Punter Southall
More simply, the basic principle is that it’s a DC scheme with an extra level of guarantee and some element of risk sharing between members and/or employers.
According to RSA/Aon research on the best like-for-like comparison, a collective pension would on average have outperformed an individual pension by 33% and in 37 of the past 57 years, a collective pension would have outperformed individual DC pensions.
Even Parliament has recently turned its attention to the arcane subject of CDC, with Frank Field MP chairing a Work & Pensions select committee on the subject.
Royal Mail’s group HR director, Jon Millidge, told the committee: “I think CDC gives us a much better outcome for people than a traditional DC scheme. It removes the individual risk that people get in the build-up to retirement – it pools that risk. It reduces the risk of them being big losers when it comes to retirement, so it gives them a better outcome.
“Providing our people with great pensions is important to us and it is very clear that the current pension scheme – the defined benefit pension scheme – has become unaffordable. The cost has increased for the company from about £400m a year to a projected cost this year of £1.2bn for pension costs. We think this provides much better pension outcomes in an affordable and sustainable way.”
But there are snags with CDC as the Dutch found out in the 2008 financial crisis. David Pitt-Watson, leader of the Tomorrow’s Investor Project at the Royal Society of Arts (RSA) says: “We hit 2008 and, of course, at that point it did not look like you had the money that you had before. What are you going to do: keep paying out the same pensions to people or do you bring down pensions in payment?
“The Dutch brought down pensions in payment by an average of 2%. That was what was needed in order to get things balanced again and to make sure you did not have an intergenerational transfer.”
These benefit cuts have priority for restoration, if and when financial conditions improve. By contrast, in the UK, the cost of buying an annuity increased by 29% over the three years 2009-12 – giving a permanent reduction in retirement income.
Mr Pitt-Watson warned that in the Dutch crisis, “communication was critical because everybody thought: ‘Hang on a minute; I thought I was absolutely promised that money’, and you can imagine that they were –so you do need to be very clear about communication. That is number one.”
So far, the Royal Mail is the only UK firm to express a firm interest in launching a CDC. As Hugh Nolan, president of the Society of Pension Professionals, says: “Only 12% of DB schemes are open to new members so it seems likely that most employers with such schemes have already moved to DC for new employees at least.
“Some of these 700 schemes might find CDC appealing if it comes into force, although many may prefer to stay with the DB schemes or finally succumb to the DC move.”
Brian Henderson, a partner and director of consulting at Mercer, agrees: “CDC presents opportunities for a softer landing than DC for members of DB schemes whose employers deem their costs too high or too volatile.
“But the number of employees in the private sector accruing DB benefits fell from 3.6 million in 2006 to just 1.3 million in 2016, and will likely drop to below 1 million by the end of 2018. It seems unlikely that employers who have transitioned from DB to DC would switch again in the short-term to arrangements that require DB-like governance.
Therefore, if CDC is to melt into the mainstream, it will likely require public sector institutions and employers like the Royal Mail to adopt it. This means that CDC would probably thrive as an alternative to final salary pensions rather than an alternative to DC.
What are the risks?
The key risk to members of CDC is one of intergenerational fairness. That is, the first cohort of members in receipt of a pension may receive more (or less) than subsequent generations. This could be exacerbated if any form of guarantee is included (for example, if pensions are guaranteed not to fall while in payment) because this could lead to lower starting pension income for successive pensioners. Guarantees also introduce a funding risk to employers (as in the ultimate cost could be more than expected).
Some critics have likened CDC to a Ponzi scheme and Steven Scott, an actuary with Xafinity Punter Southall says: “The Ponzi scheme remark is a fair one. The stability of CDC depends on a regular stream of new entrants (and contributions) to generate the investment returns required to provide the expected retirement income.
“Any change in future work patterns (automation, for example), and the possibility of future company failures means that a steady stream of new entrants is not a given. For that reason, CDC should probably only be considered by the biggest and safest companies.”
The volatility of investment returns also contributes to this. During periods of strong returns, pension payouts may be high, while payouts may fall during times of poor returns.
In practice, actuaries will try to smooth out such peaks and troughs, but try as they might, it will be impossible to distribute cash from a CDC scheme without creating winners and losers.
It is difficult to manage longevity risks in a CDC scheme. In particular, contributions will be set during a member’s working lifetime at a rate deemed sufficient to provide the target income in retirement, until death.
If members live longer than expected, this will create an intergenerational cross-subsidy, as the cost of paying pensions for longer would be met by the extant working population. It is worth noting, however, that this is also true of DB schemes.
Will CDCs get off the ground?
Nolan adds: “Demand may still be limited currently but could grow in the future as the risks of pure DC become clearer to the general population over time, including when people retire on disappointingly low pensions or run out of cash during their lifetime. CDC may well have a particular role to play in the development of a good decumulation product.”
David Fairs, pensions partner at KPMG, says: “It would be feasible to set up a CDC arrangement to just deal with decumulation. This would potentially be a highly attractive vehicle because of its ability to create predictable but flexible retirement incomes.
With transfers from DB to DC arrangements running at around £20bn-plus, there is a demand for a product that provides flexibility with a predictability that is not being satisfied by the market.
He adds: “Such an arrangement could be attractive to a large employer as a tailored arrangement just for its own staff or as a multi-employer arrangement.”
On the starting blocks
Kevin Wesbroom, senior partner at Aon, says that CDC “absolutely will happen”. He says: “Royal Mail and CWU will see to that. The DWP has been brought in to the idea, on the grounds that it won’t be just a one employer solution.”
But Bob Scott, senior partner at Lane Clark and Peacock, says that there is a great deal that would need to be done (in the legislative sphere) before CDC could be viable. With Brexit taking up much of the Government’s legislative timetable, it’s unlikely that we will see anything widespread in the near future.” Likewise, David Brooks, technical director at Broadstone, is not convinced: “This feels too late to stop the stampede to DC schemes.”
But don’t rule it out completely. Steve Webb, director of policy at Royal London, concludes: “Many employers will not be interested in sharing any of the risks around pension scheme funding, but if the right legal and governance framework can be put in place, it could be valuable part of the spectrum of the pension structures available in the UK workplaces.”
What CDC pensions mean for employees
- Possible better retirement outcomes compared with DC saving. Collectivisation of investments across CDC members may lead to better investment returns due to: Lower fund management charges; More active involvement in investment management decisions by qualified professionals; Assets held in respect of CDC pensioners may continue to be invested in return seeking assets (for example, equities) that would be expected to generate a higher return (and better retirement outcomes).
- Member expectations. CDC schemes will be required to provide members with a projection of their expected future retirement benefits, which will set members’ reasonable expectations. If members plan their retirement based on these projections, and if the actual income received is significantly less, members will have little time to adjust their retirement plans. This is a particular issue for CDC if the target income is expressed in the same way as the pension from a defined benefit scheme is (ie the Royal Mail CDC will target a similar form of benefit to what would have been provided via the Royal Mail DB scheme).
- Uncertain retirement income. Members will have no certainty over retirement income and, unless guarantees are provided, may end up with a far lower income than expected. Further, income may fall in retirement if asset returns are poor. It will then be very difficult for members to rectify this situation (ie they may no longer be able to work).
- Loss of control. In particular, CDC schemes may restrict members from accessing their pension savings flexibly for the reason of maximising investment returns (if funds are being withdrawn by members, for example, through freedom and choice, it will be harder for the CDC scheme to generate the returns required to meet the expected pension income).
- Intergenerational fairness and the impact of volatile investment returns.
Source: Steven Scott, actuary, Xafinity Punter Southall