August saw the official launch of a new type of pension scheme. So what is a collective defined contribution scheme, and is it something you should be considering for your people?
For as long as payroll departments have paid into pension schemes, the schemes into which contributions have been paid have fallen into two categories. Defined benefit schemes pay an income for life and (usually) a lump sum on retirement that is guaranteed by the employer. Defined contribution schemes don’t guarantee a specific sum, instead using a pension pot, the value of which may increase or decrease depending on the contributions made and the success of investments.
Now, there’s a third type of pension: the collective defined contribution pension scheme (CDC), which was introduced by the Pension Schemes Act 2021 and formally launched on 1 August 2022.
According to the Government, this alternative scheme has “the potential to provide improved retirement returns for savers, with more predictable costs for employers.”
Minister for Pensions, Guy Opperman, said:
“CDC schemes have the potential to transform the UK pensions landscape. We have seen the positive effect of these schemes in other countries and it is abundantly clear that, when well designed and well run, they have the potential to provide a better retirement outcome for members and can be resilient to market shocks. I have no doubt that millions of pension savers will benefit from CDCs in the years to come.”
But will they?
What is a collective defined pension scheme?
In a CDC, and as the Government states, “Employers and employees contribute to a collective fund from which individual retirement incomes are drawn, with trustees responsible for oversight to ensure schemes are viable and can meet their legal requirements and commitments to members.”
Unlike the define benefit scheme, there’s no guarantee of returns. Instead, a CDC works to a target, but where the scheme is over or underfunded compared to that target, it can pay more or less than was originally planned.
Are CDC’s already in use?
As the Pensions Minister noted, such schemes are already in operation in Denmark, Canada and Netherlands. Although now approved in the UK, no such schemes are currently in operation, although it seems highly likely that that’s it’s only a matter of time before the first are approved (see below).
What are the pros and cons of collective defined contribution pension schemes?
On the face of it, it doesn’t sound like an entirely attractive package. No guaranteed income adds an air of uncertainty to the scheme, certainly when compared with a defined contribution pension. If the scheme misses its target, pension payments will be lower than expected. It is possible that some members of the collective scheme will be worse off than they would be in other schemes (about which, more in a moment).
But first, the benefits. The problem with a guaranteed scheme is that payments may need to increase to ensure the guaranteed sum is achieved. If you don’t guarantee a sum – as is the case with a CDC – neither employees nor companies are forced to pay additional amounts – so a CDC can certainly be the cheaper and more certain way to fund a pension.
Because a CDC is a collective scheme, there will always be some members of the scheme who are paying in while others are receiving payouts. Some experts argue that this enables a longer-term investment strategy than alternatives.
Longevity risk sharing
The biggest potential advantage of a CDC comes from its unique structure. In a defined scheme, each member has access to their own ring-fenced pension pot. They run the risk of having lots of unused funds if they die young. They run the risk of running out of money if they don’t. Balancing that risk, therefore, is crucial, but because the pension pot is an individual one and none of us knows when we’ll die, it’s a difficult balance to strike.
The collective nature of a CDC makes that much easier and means payments can be calculated based on average life expectancy of all those in the scheme.
Longevity risk sharing can create issues. As noted earlier, those dying youngest may lose out compared to the position they would have been in if they’d had a defined pension. Transferring out of a CDC scheme can be messy although not insurmountable.
Yet with a well-managed scheme, it may be that employers and employees see more upside than down.
All eyes on Royal Mail
Although no CDC scheme is in operation in the UK at present, Royal Mail is expected to be first of out of the blocks with a scheme that has been in development since 2018. Its success will be keenly scrutinised by the industry and will determine how great a part CDCs play in the UK pensions landscape of the future.
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