In supporting transparency and fairness, the UK’s collective defined contribution (CDC) scheme design may produce more volatile outcomes than international implementations, where volatility is managed through buffers using a funding gate mechanism.
CDC pension schemes were introduced as part of the Pensions Schemes Act 2021. However, the Pension Policy Institute (PPI) believes the legislation is flexible enough to support other applications for CDC schemes.
The institute warned that maintaining the aim of greater transparency and fairness in the UK will lead to challenges for decumulation CDC schemes as they will need to operate without smoothing mechanisms, such as buffers, and with a more limited time horizon of future liabilities than whole-of-life CDC implementations.
Investment performance
The PPI said the majority of risk and volatility issues in CDC decumulation stem from investment performance, and therefore schemes will need to consider within their objectives the balance of a higher opening benefit level and the degree of predictability of future benefit levels that can be provided.
Within the fairness considerations of a scheme, it said it is “imperative” that the sharing of longevity risk be fair. PPI said this would require consistent underwriting ensuring that personal longevity risk is consistent with the aggregate longevity risk within the scheme.
Scale
The instritute added that insufficient scale is more of a threat to the economic viability of a decumulation CDC scheme than to its effective risk pooling. It said that risk-sharing between members still operates effectively at a scale below which a scheme may not be economically viable but the benefit level offered by very small schemes will inevitably be less predictable than that offered by larger schemes.
For a scheme to be of sufficient scale to be economically viable, it must be able to implement a charging structure allowing it to cover running costs, as well as recover start-up costs including authorisation fees, it stated.
The PPI added that the minimum economically viable size will depend upon the number of members and the total assets under management, but may be equivalent to that required for a master trust.
Competition
PPI said that interaction with other decumulation options, both as competition and compliment, will determine the CDC model’s success.
It added that decumulation CDC will face competition from existing decumulation products, new products within the current framework including blended solutions, alongside additional potential competition from multi-employer CDC schemes.
Communication
But the “single biggest challenge” for CDC’s to overcome is communication, according to the PPI.
It said that experience from the Netherlands, where communication with CDC scheme members failed to align expectations with the realities of the systems, resulted in reduced trust in their pension system and, ultimately, was a contributory factor to the reforms which will come into force as the new Dutch pension agreement.
Introducing decumulation CDC to the pension market will make a complicated decision more complex, according to PPI and therefore it will be important to consider where decumulation CDC is positioned within the advised and guided markets and how decumulation CDC should be positioned between the certainty of an annuity and the flexibility of an individual drawdown product.
John Upton, policy analyst at the PPI, said that the institute constructed different models to explore how issues could play out in a wide range of circumstances.
He said that the modelling results showed that decumulation CDC, investing more aggressively than an annuity, would generate a larger benefit for members on average.
However, because of the way a CDC scheme is currently anticipated to be legislated, the change in benefit that a member would see each year would be sensitive to investment performance, making it less attractive to savers who may not have capacity for this uncertainty, he explained.
“The results suggest that chief among a decumulation-only CDC scheme’s considerations would be the investment strategy, allowing both the possibility of delivering attractive benefit levels, and the risk of not meeting member expectations of an income-for-life product,” he said.
Upton said there is a “home” for decumulation-only CDC in the retirement product space “perhaps by complementing other products rather than competing with them”.
He added: “For someone who already has a suitable underpin from another source, decumulation CDC may offer a way to make their DC pot go further, without having to make complex decisions regarding longevity or investment whilst accepting greater uncertainty.”
Ruari Grant, policy lead for DC at the Pensions and Lifetime Savings Association, said: “By pooling longevity risk and investing in higher growth assets than guaranteed retirement products, CDC can offer retirees higher average lifelong incomes.”
However, he said that while savers in a CDC won’t have to worry about running out of money, the year-to-year benefit level is less stable, particularly in a scheme with a more aggressive investment strategy.
He continued: “We do not yet have regulation in the UK enabling decumulation-only CDC schemes, so we will continue to work with the government to establish a regime which sets high standards on areas such as member communications and scheme governance.”
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