CDC schemes – changing the UK pension landscape?

Our analysis shows that defined benefit (DB) pension schemes are becoming increasingly mature and most are well along their journey to the endgame.

This is one of the key findings from DB End Gauge, our monthly index that estimates the average time for UK pension schemes to reach a sufficient level of funding to buyout their DB liabilities.

As the costs and risks associated with these legacy schemes reduce, corporates will begin to switch their focus to the pensions they are providing for current employees. In most cases these employees will be members of a defined contribution (DC) scheme, put in place by the company after the DB scheme was closed to new entrants.

Generally, the contributions employers make to DC schemes are significantly lower than those paid into DB schemes. Companies may now start to see that a (quite possibly not insubstantial) number of their employees cannot afford to retire when they want to - or when the company would like them to - because their DC pensions are not going to be enough to support them in later life. This may give the company workforce planning issues, so continuing with the existing DC pension structure for new hires and younger employees will only exacerbate the problem over time.

Companies should be examining whether their DC contribution structure is suitable and exploring if DC contributions need to be increased as DB costs start to reduce. More radically, companies may want to think about alternative ways of providing pension benefits, whether by supporting their employees to automatically convert DC savings to a lifetime income, or by using a new type of arrangement - the Collective Defined Contribution (CDC) scheme.

". . . companies may want to think about alternative ways of providing pension benefits, whether by supporting their employees to automatically convert DC savings to a lifetime income, or by using a new type of arrangement - the Collective Defined Contribution (CDC) scheme."

The pros and cons of CDC schemes

Getting better outcomes for members is the clear advantage of CDC.

Economies of scale should mean that costs can be managed efficiently, with the scheme able to access and effectively govern wider investment opportunities. As the scheme cannot have a deficit (the benefits must be reduced if there are not sufficient funds in the scheme) there is a reduced need to manage volatility on the sponsor balance sheet, and so the trustees are free to invest in return-seeking assets rather than pushed towards fixed income and government bonds to match liabilities. Some management of the volatility will nevertheless be desirable in order to keep the benefit estimates relatively stable.

Members do not need to decide what to do when they retire. The scheme pays each of them a pension on retirement, rather than forcing every member to make a decision about buying an annuity or how to draw an income. And neither would members be required to make investment decisions before or after they retire – this is all managed by the trustees of the scheme.

"Members do not need to decide what to do when they retire. The scheme pays each of them a pension on retirement, rather than forcing every member to make a decision about buying an annuity or how to draw an income."

Communication is important so members understand the benefit they expect to receive and when adjustments to those benefits apply. Since there will be an adjustment each year, members of CDC schemes should be able to see the value of their estimated benefit change, along with the performance of the scheme’s investments over time. The adjustments to benefits can be smoothed over a number of years, so their income in retirement should be fairly stable and predictable.

For companies, the fixed contributions mean pension costs are predictable and contained; the scheme cannot have a deficit like a DB scheme as the benefits must be adjusted each year depending on the performance of the investments.

"For companies, the fixed contributions mean pension costs are predictable and contained."

For the risk pooling to be efficient, CDC schemes need to have scale and so only the very largest employers, like Royal Mail, will be able to set up their own standalone schemes. For other employers the obvious solution is for CDC to be available on a multi-employer or master trust basis; regulations to enable this are planned in 2022.

CDC schemes will need to meet a charge cap that is expected to work in a similar way to the DC charge cap. This could limit the advantages of asset pooling (for example, some investments in private markets will be difficult to access because of performance related fee elements).

Companies need to rethink their employee pension strategy

We believe that employers should now revisit their pension strategy for current employees and answer the following questions:

• What are your employees’ retirement needs? Does your current DC scheme provide them with a way to achieve these needs? Are you building up employment issues for the future? Our GEM tool enables employers to answer these questions and make informed decisions based on in-depth analysis.
• If you have a legacy DB scheme is this under control with a suitable long-term objective that takes into account the needs of all stakeholders (trustees, employer, shareholders etc)?  Our DB Navigator framework can help employers build a robust endgame journey plan that recognises your corporate objectives and constraints.
• Would CDC be a viable alternative to your current DC scheme? Can you afford to increase contributions as DB costs become increasingly under control? Our Employer Consulting team can help you design and implement a sustainable pension scheme that meets the needs of your employees.

For more information about this topic, please contact your usual Barnett Waddingham consultant. You can also get in touch with the author below.