Many people reaching retirement age in the UK today have a combination of Defined Benefit (DB) pension promises and individual savings through Defined Contribution (DC) pension arrangements. This mix of DB and DC provides a nice blend of guaranteed income plus flexibility.

Difficult DC decisions

However, in the future, the majority of people (myself included) will not have any DB benefits. As a traditional DC scheme does not provide a pension in retirement, retirees have very important decisions to make about how they manage their DC savings pot. Using some or all of the pot to purchase an annuity provides a guaranteed income, but this can be expensive.

As we have seen recently, you are at the mercy of annuity rates at the point of retirement, which can vary significantly year-on-year with market conditions (although some of this can be hedged through the investment strategy). Flexible drawdown can be an attractive solution for some, particularly those with large pots, but leads to uncertainty around suitable withdrawal rates, and a risk of running out of money for those with smaller pots. 

So the question is: can we do better? Is there an alternative arrangement where employees can have more certainty over their income in retirement compared with traditional DC, without the need for complex decision-making, but where the costs are manageable and predictable for the employer? The answer could be CDC.

What is CDC?

Collective Defined Contribution is a type of pension arrangement where members of the scheme pool investment and longevity risk. By sharing risk across the membership, this can provide more certainty and a smoother retirement journey compared with current traditional DC arrangements.

The key features of a CDC scheme are: 

The charts below show results from abrdn’s CDC simulator, which models the running of a CDC scheme over time, with pension increases calibrated each year to balance the funding position. The model is just for illustration at this stage and there are a number of key variables that affect the results. In future articles, we will provide more detailed results to demonstrate different elements of CDC. As a first step, the results below demonstrate the link between investment performance and pension increase. If investments outperform expectations, the pension increase award goes up, and vice versa. 

As the calibration includes the assumption that the same pension increase is paid each year in the future (for the purpose of the actuarial calculation), the change in the pension increase award from one year to the next is much smaller than the annual investment return. This can be viewed as one of the smoothing mechanisms within CDC. In the simulations above, there are other factors impacting the pension increase such as mortality experience and the ageing of the membership (as our model scheme starts with no pensioners). We will cover the impact of some these different aspects in future articles.

Decumulation-only CDC

What we have described so far is a whole-of-life CDC scheme but there is another type of CDC arrangement being discussed in the industry called decumulation-only CDC. In a decumulation-only arrangement, the principle is the same except members would purchase a CDC pension at retirement (converting a pot of money to CDC pension) rather than accruing pension each year through their working life.

Is CDC a good idea?

On paper there are a number of potential benefits to members of CDC schemes over other arrangements like traditional DC. Four key benefits are:  

Due to the pooling of investment and longevity risk within the scheme, it has been shown that a higher expected benefit level can be achieved than current options for DC members such as annuity purchase and income drawdown. The main reason for this is that, by sharing risk, a CDC scheme can have a higher allocation to growth assets than would be palatable for each individual member over their whole life. The subject of investment risk sharing is a complex one and we will come back to this in another article.

An income for life in retirement?

Surveys in the UK repeatedly show that what people want from a pension arrangement is the security of an income for life in retirement. CDC provides this by default. Arguably CDC pension benefits can be more intuitive for a member to understand versus traditional DC. Members can compare current accrued pension with current salary and expectations of retirement income requirements to determine if they are saving enough into their CDC arrangement. A traditional DC pot valuation has the risk of appearing like a relatively large number, but it is very difficult to evaluate whether it will be sufficient over a member’s whole life in retirement.

Communication is key

Clear communication to members is key to ensure an understanding of the risks, in particular that accrued benefits should be viewed as “target” and not guaranteed. Pension increases vary over time, allowing members to benefit from the upside of strong investment returns but also to feel the downside if investment performance is poor.

Although the premise of CDC sounds attractive, there is ongoing debate regarding some of the challenges of CDC, including finding the right balance of fairness to all members with the desire for smoothing, which will always have winners and losers in retrospect. Opinions in the pensions industry are divided.

Will CDC happen in the UK?

CDC has been debated for many years, but attention has grown significantly over the last two years as The Pension Scheme Act was updated to provide the legislative framework to establish and operate single-employer CDC schemes in the UK. The theory of CDC is now able to be put into practice. Royal Mail is expected to be the first employer to operate such a scheme to provide CDC benefits to their very large workforce.

At the beginning of 2023, the Department for Work and Pensions (DWP) consulted on a proposal to extend the regulations to allow multi-employer CDC schemes / CDC master trusts. This would provide the opportunity for both industry-wide CDC schemes and commercial CDC master trusts. It is clear from the consultation that there is growing support for CDC in the UK and so, now more than ever before, there is potential for CDC to result in a step change for how pensions are provided in the UK.