Likely changes to legislation mean the UK could potentially see multi-employer CDC schemes / master trusts in the next few years, and maybe even mass adoption.
Towards a stable membership profile
In the event that CDC takes off in the UK, there will be a number of difficulties for new schemes to overcome. One key challenge for CDC schemes that employ investment risk-sharing relates to membership stability.
A stable membership profile within a CDC scheme (a stable duration of accrued target liabilities, to be more precise), means that over a member’s life, depending on the scheme design, they will take more investment risk when they are younger, but benefit from reduced investment risk in old age. This is a design feature of CDC and has its advantages (see our previous article, How does CDC risk-sharing work?).
…you may benefit from being an early joiner in a new CDC scheme…
However, a new CDC scheme is unlikely to have a stable membership profile from day 1. The initial membership is likely to be current employees only (all non-pensioners). It will take time, perhaps 30-40 years for the membership profile of the scheme to reach a steady state of non-pensioners and pensioners, assuming new joiners each year.
Are there risks or rewards for early joiners?
How does this initial maturity of the CDC membership impact risk and outcomes for original members? In summary, you may benefit from being an early joiner in a new CDC scheme. Here’s why:
In a CDC scheme that employs investment risk sharing, the investment risk for older pensioners is passed to younger members, although the level of risk-sharing depends on the CDC specific design. The level of investment risk a member takes on is linked to how the duration of their accrued benefits compares to the average across the membership. If there are no current pensioners, there is no risk to pass down.
So, although there is some risk-sharing between the initial joiners (a 55-year-old takes less risk than a 25 year old), as there is less dispersion of ages than an established CDC scheme (e.g. no 90-year-olds), the quantum of investment risk-sharing is much lower.
However, if we travel 50 years into the future, members who initially joined the scheme at age 25 are now 75 and, assuming there were new joiners to the scheme over the period, the risk-sharing mechanism will mean the original members reap the benefits of low investment risk in old age.
…the volatility of pension increases goes up over time…until a stable membership is established around year 40.
Another way to see the benefit of being an initial member into a new CDC scheme is to look at the volatility of pension increases over time. Using abrdn’s CDC simulator(1) , we ran stochastic simulations of a new CDC scheme over the first 100 years. To illustrate the point (and for simplicity), we have assumed a constant investment strategy throughout the simulations with volatility of 10% p.a.
The model assumes a group of initial members (non-pensioners) with new members joining the scheme each year. The results show that the volatility of pension increases goes up over time, as the membership ages (the duration of accrued benefits falls), until a stable membership is established around year 40.
Winners and losers?
Once the scheme reaches this steady state, new joiners from here will miss out on the initial period of lower volatility of pension increases. In our modelling we have assumed the same investment strategy throughout. In reality, the investment strategy could change over time to reflect the membership profile, but for simplicity we have not allowed for this here.
Chart 1: Volatility of pension increases
Chart 2: Duration of accrued target benefits
If the initial members of a new CDC scheme are the winners, who are the losers? The answer is the last group of members in a CDC scheme. Now, if the scheme is a success and remains open, there will never be a 'last' group of members. However, as we have witnessed in the Defined Benefit (DB) pensions market, there is always a risk that any new scheme might have to close in the future due to unforeseen factors such as market conditions and regulatory changes.
In a CDC scheme that continues to operate after closing to new members, the membership will mature over time (like we see in DB). If you are a younger member at the point the scheme closes to new members, you will continue to take on additional investment risk today (offsetting lower investment risk taken by current pensioners), but in the future once you become a pensioner, there are no younger members in the scheme for you to share risk with.
In this scenario there are expected to be triggers where the CDC scheme will have to reduce risk in the investment strategy, but this will come with reduced expected return for the last group of members. Ultimately provisions will have to be made to move members to a different arrangement.
Protection for last members
Is it fair that the initial group of members have a more attractive arrangement, and what protection should be in place for the last group?
As CDC is just getting started in the UK, perhaps there should be an incentive for initial members to help get it off the ground? Alternatively, a mechanism could be constructed to somehow pass this benefit from the first generation to the last. There has been discussion within the industry of some form of reserve established for CDC, which can be used in the event the CDC scheme does have to wind-down.
This may be funded by the provider but there is an argument that this could be funded by the first generation. A very small charge / premium on contributions made over the first 30 years, for access to the more attractive investment risk profile. The last generation would then get uplifts / bonuses using the reserve to compensate for their unattractive investment risk profile.
This article focuses on a simple CDC design, with a constant investment strategy throughout. There are more complex approaches that can reduce some (perhaps even all) of the investment risk sharing by having pre-defined de-risking investment journey plans for each member, which are then aggregated up to get an overall investment solution for the scheme based on the make-up of the membership.
Although this can overcome some of the challenges relating to fairness for new CDC schemes, it also introduces others such as added complexity and has the potential for lower overall benefit levels.
- More information on our CDC simulator and assumptions underlying the model can be provided upon request.