The UK finally legislates for a collective alternative to pure DC. But will employers be interested?
- Collective defined contribution schemes (CDCs) share risks across generations
- The government will soon publish regulations allowing UK employers to set up CDCs
- Employer appetite remains unclear
As autumn arrives, so does the prospect of a shake-up in the UK’s occupational pensions provision.
The doors will be opening to a new type of scheme which is not just intended to lessen the burden on employers posed by defined benefit (DB) schemes. It should also provide more intergenerational fairness between members. Another goal is to allow pensioners to de-risk over time instead of buying an annuity as a once-and-for-all event.
Collective defined contribution (CDC) pension schemes are used in countries including Canada, Denmark and especially the Netherlands.
They are a variant of DC schemes in which each member’s savings are pooled with everyone else’s, so longevity and investment risks are shared across generations.
On retirement, members are paid a cash lump sum and a pension income that should be higher and more predictable (a target is set) than they would receive from an individual DC plan. The amount paid will fluctuate each year according to investment returns. However, while amounts paid out may be lower than the possible maximum amounts available for high–performing DC plans, members are likely to be protected from very low returns.
Furthermore, during retirement, savings will still largely be invested for return (though moving gradually towards less risky investments), allowing the member to benefit from future market increases.
CDC pensions were not allowed by UK law until the Pensions Act 2021 created the basis for the legal framework. Once the regulations – expected later this year – take effect, sponsoring employers that wish to will be able to set up CDC schemes.
First off the blocks is likely to be the Royal Mail, whose intention to create a CDC scheme has been a significant factor behind the new legislation (see box).
A consultation by the Department for Work and Pensions (DWP) on the regulations governing CDC schemes closed in August.
The response, both in written submissions and in public comments, generally favours the concept.
Shriti Jadav, CDC director, Willis Towers Watson (WTW), says: “We see the introduction of CDC to the UK as a real positive, helping to meet a demand that neither DB nor individual DC can meet. We believe that, in time, CDC could play a key role in the UK pensions landscape.”
A spokesperson for the Church of England Pensions Board (CEPB) says: “We see that CDC schemes potentially offer better outcomes for members than traditional DC, without the cost uncertainty of DB, and we responded positively and constructively to the consultation.”
“We see it as a good thing for pensions in the public interest,” says the Institute and Faculty of Actuaries (IFoA). “It is inevitable that over time, as experience emerges, the regulations will need to evolve. However from an actuarial perspective we see these drafts as being fit for purpose for initial regulations, subject to [certain specific comments].”
But Prof David Blake, director of the Pensions Institute at City, University of London, cautions: “It has taken a very long time for the government to get around to providing a legal framework for CDC schemes. It is equally going to take a long time to see whether they catch on. This will depend on how successful the schemes of early starters like Royal Mail turn out to be.”
At a practical level, a number of issues have prompted suggestions for changes to the proposed rules.
A popular demand is for greater flexibility, with pension consultant LCP saying this should encourage greater take-up and make it fairer for younger members.
LCP partner Steven Taylor says: “They need to be far more flexible, as the regulations as they stand are primarily based on the Royal Mail scheme. Many company schemes won’t fit neatly into this mould and this will hinder take-up of CDCs. There also needs to be more thought around how the scheme design can be made fairer across the generations and ensure that younger members aren’t subsidising older members.”
There is support for the government’s future plans to extend the CDC framework to cover multiple employers and industrywide schemes; at present, the rules only apply to single employers and connected employers.
“We see the introduction of CDC to the UK as a real positive, helping to meet a demand that neither DB nor individual DC can meet” - Shriti Jadav
LCP says the criteria for multi-employer schemes need to be developed: “It needs to be made easier for groups of companies currently participating in group pension arrangements to have the option to move to CDC should they want to,” it adds.
The Pensions and Lifetime Savings Association (PLSA) says, “It is not clear that there is demand from [single] employers to provide such schemes, particularly as many have already invested heavily in high-quality individual DC provision.”
Master trust CDC
The CEPB has suggested the draft regulations could helpfully adopt a broader definition of connected employers, so that employers with a significant common interest and shared identity could participate together in CDC arrangements, as they can in DB schemes.
“It is really encouraging that [pensions minister] Guy Opperman describes these initial regulations as a first step, the next steps being ‘extensive multi-employer engagement’ over autumn and winter, and multi-employer and/or master trust-specific regulations possible next year,” says Jadav. “We are currently working with two organisations looking to take part in this. We believe multi-employer and/or master trust CDC schemes will be required for CDC to really gather momentum, allowing benefits to be provided more easily and cost-effectively and making CDC more accessible for employers.”
Meanwhile, other suggested areas for improvement include the concept of soundness in respect of the scheme design, which needs to be more clearly defined, as it is currently open to interpretation, according to the official response of the PLSA on its website.
“This is also true for the supervisory regime,” it says.
The IFoA agrees. In a statement it says: “There is no definition of ‘soundness’ provided, although it must be considered by the actuary, the trustees and the regulator. This is problematic for scheme actuaries and trustees who will need to certify or report on soundness, and we would urge DWP to make a change in this respect.”
It also says that the provisions allowing the scheme actuary to adjust the valuation results for post-valuation experience should be removed, or, at least, significantly amended.
“The prospect of allowing for post-valuation experience will make the process of deciding on an appropriate increase rate more complicated than if decisions are made based on conditions at a fixed date [the valuation date],” it says in its submission.
Royal Mail leads the way in collective DC
In March 2018, the Royal Mail Pension Plan – a defined benefit (DB) scheme, with about £11.4bn (€12.6bn) in assets and 124,000 members in total – closed to accruals because future benefits would have become unaffordable.
The company’s pensions team – advised by Willis Towers Watson and Aon – held detailed discussions with the Communication Workers Union (CWU), advised by First Actuarial, and agreed to develop a scheme that was sustainable, affordable by the company, and secure for members.
The whole process was carried out as a collaboration between the company and the union.
“We have also been keen to learn from other CDC models,” says Angela Gough, head of corporate pensions, Royal Mail. “We wanted to design a plan with minimum intergenerational unfairness and we believe it addresses that.”
The new pension scheme will be made up of a collective defined contribution (CDC) section and a cash lump sum section (similar to the existing DB cash lump fund, currently worth £1.2bn), with virtually all employees in both.
Within the CDC scheme, members will contribute 6%, and the Royal Mail 13.6%, of pensionable pay.
Members will accrue 1/80 pensionable pay each year in the CDC section, and 3/80 in the cash fund. The benefits will be a guaranteed lump sum from the cash fund plus an income in retirement, which will fluctuate depending on investment returns and demographics.
“We won’t be using capital buffers to help reduce the unpredictability of income levels, as buffers can place unfair burdens on particular cohorts of members,” says Gough.
The new scheme’s charges will be decided by the trustee board, but the CDC section of the scheme is subject to a charge cap. There will be an annual valuation, determining whether the level of the wage goes up or down, and by how much, for each year.
Scheme members will not have to buy an annuity. Instead, the CDC section will hold return-seeking assets in respect of all pensions pre-retirement. Post-retirement, assets will gradually de-risk.
The pension fund’s high-level investment strategy, agreed between management and unions, is to target global equity returns with lower volatility.
Trustees are also planning an additional DC nursery scheme with a lower level of contributions for those with less than a year’s service, or who opt out. But like the existing schemes, neither will be compulsory.
Because the CDC framework had been prohibited by UK law, the Royal Mail was talking to the Department for Work and Pensions (DWP) right from the start.
“It was worth the time and effort to do this, as we’ve had a lot of support from pensions minister Guy Opperman, the DWP and MPs,” says Gough. “We’re hopeful that all the work we’ve done with government and regulators means that future plans can be set up more quickly and easily.”
With Pensions Act regulations due to be published this autumn, there will also be a formal consultation with staff and unions on the scheme’s operation. These will be followed by a detailed communications plan closer to launch, the exact timetable of which is a matter for government.
But if everything goes smoothly, the plan is expected to launch in 2022.
The company has communicated with members through its in-house TV programme and magazine, taking advice from communications experts. Besides explaining how the new scheme works, the messages included updates on legislative progress.
It also suggests the current position is likely to be difficult to monitor from a practical perspective, and could potentially increase costs.
LCP says CDC schemes need to be more easily workable for auto-enrolment purposes by allowing flexibility to build up benefits at more than one rate. The consultancy expects this also to help to highlight to sponsors that CDCs can be used to provide affordable benefits across the whole workforce.
According to Blake. however, there are problems with the basic CDC concept as a whole.
He says: “While it should be fairly easy to get employers and members to sign up to the principles of a CDC scheme, it is another matter altogether to get retired members to accept cuts in their pension when the algorithm signals this in response to poor investment performance.”
He points out that this has happened in the Netherlands in the past few years: “There were howls of anger from Dutch pensioners – and now the Netherlands has moved away from CDC towards individual accounts.”
Blake highlights the current problem with the triple lock in the UK: “And this is not about a cut in pension, it is about a lower increase than the rules indicate. To me, this is always going to be one of the main problems with CDC. They may provide on average more stable and reliable pensions than individual DC schemes, but can they survive periods when pensions have to be cut?”
He suggests that overcoming ‘reform exhaustion’ presents another problem: “There have been so many reforms to, and innovations in, the pension system over the last few years – auto-enrolment, pension freedoms, consolidation, the dashboard. Is there enough energy left to try another one?”