The government is considering introducing “collective defined-contribution” pensions as a middle road between existing options. Could they represent the future of saving? Simon Wilson reports.
What are CDC pensions?
Collective defined-contribution (CDC) pensions are a halfway house between the two current main types of pensions offered by employers in the UK. These are, first, the now rapidly vanishing “defined-benefit” (DB) schemes, in which workers receive a specified regular pension income in retirement paid from a collective fund. And, second, the “defined-contribution” (DC) system, in which employer and employee make regular contributions to an individual savings pot, which is invested and hopefully grows gradually over the years. The retiree then buys a pension product (an annuity or a drawdown-based product) on retirement.
How is CDC different?
CDC schemes are similar to the second, DC system, but savers pool their money into one “collective” fund, rather than having their own individual accounts. The idea is that the risks are shared by all members of the scheme, rather than shouldered by each saver individually. Upon retirement, the scheme pays out a pension, but the crucial difference between this and normal DB and DC schemes is that a CDC scheme offers a “target” income rather than a hard promise of a specific sum for life. That sum can fall (for example if markets fall heavily and the fund needs to retrench) as well as rise if the assets are particularly well invested.
Doesn’t the employer cover that gap?
No. The idea is that the members of the scheme, both pensioners and younger workers still paying into it, share the ups and downs of investing. In times where markets are down, pension payments can be reduced and contributions can be increased. Following the 2008 financial crisis, for example, a quarter of Dutch CDC schemes were obliged to cut payments (by 1.9% in 2013 and 0.8% in 2014). It’s early days for CDC schemes in the UK. The government, which believes they have the potential to offer higher and more stable incomes, has just announced a three-month consultation on whether to make them available in the UK. Royal Mail is eager to crack on with its CDC scheme for its 140,000 members (with strong support from the Communications Workers Union) and the government says it wants workers to benefit as soon as possible.
What are the advantages of CDC?
They are potentially an attractive option for people for whom buying an annuity feels poor value, and drawdown feels too insecure. First, “longevity pooling” avoids the need for people to in effect act as amateur actuaries on their own behalf at retirement and predict how long they will live. As the House of Commons Work and Pensions Committee put it, in a recent report backing the plan, CDCs “mimics the key benefit of an annuity – the assurance of a regular income for life – without the cost of covering the insurer’s capital buffer and profit margin”. Second, because the investment risks have been pooled, a CDC fund can take a more consistently balanced approach to investment risk, rather than (as in the case of an individual pot) shifting from equities into low-risk, low-return bonds as the retirement date approaches.
Are there other benefits?
Advocates argue CDCs will be cheaper to run – and therefore deliver higher average pension payouts than individual pots. Removing the need to buy a separate retirement product might cut the need for (expensive) third-party providers and advisers. Attempts to model the effects of CDCs on retirement payments cited in the DWP’s report (by insurance companies, government and interested charities) all find that payments would be higher by around a third (or slightly more). They would also vary less between successive cohorts of retirees. From employers’ point of view of, CDCs offer the same benefits – lower cost, no ongoing sponsorship or liability – as DC schemes.
What are the downsides?
Sceptics argue that CDCs look and smell suspiciously like “with-profits” funds, which were widely sold as pensions or mortgage endowment funds in the 1990s. About 11 million people ploughed £190bn into these pooled investment funds on the promise that they were low-risk, since annual investment returns would be “smoothed” out, and money would be held back in good years to be paid out in bad ones. Actuaries miscalculated and paid out too much at the start of the policy terms, leaving savers with paltry pensions. “Pooled funds, smoothed returns, actuarial discretion. CDC pensions really do bear a striking resemblance to with-profits,” says Tom McPhail of Hargreaves Lansdown in The Sunday Times.
Some critics, for example Michael Johnson of the Centre for Policy Studies, argue that CDCs would be too hard to marry with the newly- established regime of pensions freedoms, in which retirees get more choice over how to take and invest their savings. For example, retirees with low life expectancy might well want to contract out of their CDC scheme in order to buy an enhanced annuity. That should surely be allowed under the UK’s culture of individual choice – yet it would undermine the “longevity pooling” rationale of CDCs. CDCs also risk creating “irreversible intergenerational justice”.
Because there’s a risk that current workers will end up overpaying for benefits enjoyed by current pensioners. Sceptics, such as pensions consultant John Ralfe, fear that CDCs would in effect rely on successive generations of new members to support the entitlement of older members, making them “suspiciously like a Ponzi scheme”. Certainly, intergenerational fairness is a key concern. When some Dutch schemes trimmed payments in 2013-2014, pensioners were naturally annoyed. But those schemes that chose not to were also criticised for, in effect, transferring risk to their younger, still-working members. These are the key issues the government’s consultation will need to address if CDCs are to make it to the starting line.