The first Collective Defined Contribution (CDC) scheme in the UK is expected to be launched by Royal Mail in October 2024, with the promise of more CDC schemes to follow. So, now is a good time to consider: What is CDC and how could it improve UK pensions provision?
Our thanks to LCP’s Helen Draper and Sean Garratt for explaining the details behind this new type of UK pension scheme.
Why is CDC needed?
CDC schemes could provide benefits that are up to 50% better than traditional alternatives for the same £ amount spend, all at a known cost to the employer.
This helps today’s working population address the challenge of saving for a comfortable retirement, without the need to find additional funds in the midst of a cost-of-living crisis.
Outside of the public sector, defined benefit (DB) schemes have mostly closed and though auto-enrolment has been successful in increasing participation in pension saving, contribution rates are usually lower than to DB arrangements. This leaves many unlikely to be able to achieve the retirement they hope for.
An approach that combines the best features of DB and defined contribution (DC) – a good quality income in retirement but at a known and affordable cost – could be highly valuable to both members and employers.
What is CDC?
CDC schemes combine the structure of a DB scheme with the cost certainty of a DC scheme.
Benefits are funded by a regular and fixed contribution rate for employers and employees, but the investments are managed collectively. This allows members to share risk and achieve better outcomes at retirement than traditional DC and potentially DB arrangements.
In a CDC scheme members accrue a target benefit in the form of a pension (that can be commuted to a lump sum) payable from the scheme. Importantly, this benefit is not guaranteed. Every year, the trustee reviews the funding level. If the scheme is under or over funded, the trustee can adjust benefits, usually through amending the target for future pension increases.
This flexibility allows CDC schemes to invest in growth assets for a much longer period than typical DB or DC schemes.
How do CDC benefits compare to DC?
CDC targets higher benefits than DC, with LCP analysis indicating median outcomes of up to 50% more for the same contribution rate.
The key reason for this is the collective nature of investments in CDC compared to the individual approach of DC.
The risk-sharing nature of CDC schemes enables investment in return-seeking assets for longer. This drives better member outcomes than a traditional DC plan with annuity purchase, where investments are typically de-risked in the run-up to retirement to reduce the individual member’s vulnerability to falls in asset values.
In contrast, in CDC schemes the impact of actual returns on a member’s benefits is smoothed over time, so whether markets have a good or bad year just before retirement, a member would expect to receive broadly the same amount.
In contrast to DC with a drawdown option, CDC provides an income for life in retirement and avoids the need for the member to make complex financial decisions in old age.
How do CDC schemes respond to volatile markets?
CDC schemes allow for both positive and negative experience through adjustments to the target for future pension increases (for pensions in payment and pre-retirement). This means that when experience is positive (e.g. investment returns are higher than expected) the target increases go up, and conversely when experience is negative the target goes down.
If there are several consecutive years of negative experience, the target for future increases would continue to reduce, and eventually there is a possibility that a one-off cut would apply to pensions. The chance of this being required depends on the design of the scheme and the investment strategy.
LCP analysis indicates that in circumstances where there are several bad years in succession, a member is typically still better off in a CDC scheme than in DC.
How could CDC benefit both members and employers?
For members
- CDC targets higher benefits than DC, with LCP analysis indicating up to 50% more per £ spend. This is because collectivisation allows an investment strategy that targets growth returns for longer, and these returns support higher benefits and lower costs.
- Improved member experience relative to DC, with no difficult member decisions such as the choice of funds, annuity or drawdown at retirement, and if drawdown how much money to take from your pension each year.
- Easier to administer from a member perspective, so less chance of members being confused by the options available and making decisions that lead to poor retirement outcomes.
- More intergenerationally fair than DB as allows for age-related benefit build up (avoiding cross-subsidies).
For employers
- Certainty on the costs with no risk of future deficits. This is because the target future pension increases are adjusted to keep the funding level in balance.
- Employers are free to choose the contribution rates that best meet their and their employees’ needs (subject to auto-enrolment requirements).
- Trade Unions have been closely involved in the development of CDC schemes and are supportive.
- CDC provides higher expected benefits for their members, which could aid recruitment and retention of employees.
What’s next for CDC beyond Royal Mail?
Regulations to allow multi-employer CDC schemes to launch are expected later this year. These will allow such schemes to emerge from 2026 onwards. We are aware of several organisations who are already considering the design of their proposed CDC schemes.
In due course, new post-retirement only CDC schemes could be established, where a member would build up a DC pot during their working life and transfer to a CDC scheme on retirement.
What should I do next?
CDC is coming and will be of interest to many in the pensions industry. We would be very pleased to discuss the opportunities with you further:
Helen Draper, Partner Sean Garratt, Principal
helen.draper@lcp.uk.com sean.garratt@lcp.uk.com
020 3922 1306 020 7432 6687
You can also contact MHM Trustee Services Ltd:
Email: info@sandccarsalesharrogate.co.uk
Tel: 01423 229029
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