Collective defined contribution (CDC) pension schemes will be included in primary legislation in next year’s pensions bill, announced the Queen during the state opening of Parliament.
The Private Pensions Bill would:
- Make provisions for a new legislative framework in relation to the different categories of pension schemes. It would establish three mutually exclusive definitions for scheme type based on degrees of certainty in the benefits that schemes offer to members.
- Define schemes in terms of the type of ‘pensions promise’ they offer to the individual as they are paying in. A scheme would be categorised as a defined benefit scheme, a defined ambition (shared-risk pension scheme) scheme or a defined contribution scheme, corresponding to the different types of promise.
- Enabling ‘collective schemes’ that pool risk between members and potentially allow for greater stability around pension outcomes. It would also contain a number of measures relating to the valuation and reporting requirements for collective schemes.
Joanne Segars, chief executive of the National Association of Pension Funds, said:
“CDC schemes potentially offer employers increased flexibility and choice in how they can structure pension schemes to benefit members by providing pooled risk, smoothing, and greater certainty. This is to be welcomed.
“Defined benefit schemes have operated on a pooled-risk basis for many years and have shown considerable innovation in managing this effectively and at low cost.
“For defined contribution schemes, the focus must remain on providing good outcomes for members. CDC may well have a role to play in this, but the fundamentals still apply. Good outcomes for members are built on strong governance, low charges and investment strategies based on members’ needs.
“The real goal here has to be schemes operating at scale. Scale is a necessary precondition for CDC, but it also enables a much wider range of member benefits.
“As a result of automatic-enrolment we are already seeing the emergence of large pension schemes in the form of master trusts, which are able to offer their members high-quality investment strategies and great value for money.”
CDC helps answer some of the issues around pensions – it offers the stability of fixed contributions but with the ability to share risk over generations. However, it is reliant on there being a constant supply of new members to share the risk.
The economies of scale do offer cost savings, but the success of CDC relative to traditional defined contribution rely on taking more investment risk and being able to obtain higher returns. If these returns are not achieved – or even if they are, and members live longer than expected – then benefits can be cut.
There is also a risk that a future government or regulator might view the pensions targeted in CDC as being defined benefit in nature, placing additional burdens on sponsoring employers. It is important that any CDC legislation explicitly avoids this, or that CDC schemes are set up at a far enough remove from employers to make any such recourse impossible.
We welcome the increased focus on defined contribution (DC) pensions in today’s Queen’s speech. However, we wonder whether the introduction of rules to allow collective DC arrangements in the UK is a bridge too far for employers and the pensions industry? It comes on the back of a wave of pensions legislation in recent years, including auto-enrolment, the liberalisation of post-retirement options in the Budget and the capping of charges. These fundamental changes are already stretching all those involved in providing workplace pensions. The industry may now struggle to effectively implement collective DC (CDC), which is a completely new concept for the UK.
Quite apart from the impact on a market already in flux, there are also many well-documented flaws with CDC that are yet to be addressed. They include questions of fairness across the generations, whether risks are properly managed and whether CDC can work effectively against the background of the UK’s ageing population and shrinking workforce. CDC also appears to be fundamentally at odds with the government’s recent moves to allow complete flexibility at retirement, given that CDC schemes are specifically designed to provide a retirement income. To be consistent with the Budget’s removal of the requirement to purchase an annuity, members of CDC schemes would have to be given the option of taking their benefits as cash. This raises the question of how such a cash amount would be calculated – how would the collective DC pot be carved up?
One advantage of CDCs is that economies of scale could lead to lower charges. Lower charges are generally a good thing for DC members, but they are not exclusive to CDC. Many large DC schemes already have charges that can more than match those under CDC arrangements. And where DC charges are higher than the government believes is acceptable, the proposed charge cap is already waiting in the wings to address the issue. By announcing the cap on charges from April 2015, it appears that the government has removed one of its own arguments for CDC.
Against the background of auto-enrolment and the removal of the requirement to purchase an annuity, the announcement on CDC seems at best inconsistent with other pension policy, and at worst as another layer of complication in an already overcomplicated industry. We doubt whether employers – not to mention employees – attempting to get to grips with auto-enrolment, charge caps, face-to-face guidance and the removal of the requirement to purchase an annuity, will have the capacity (or desire) to deal with yet another pensions initiative.
It’s very welcome news that CDC will now be given the legislative framework it needs to become a realistic option in the UK. CDC may not be right for everybody but it cannot be a bad thing that the government is preparing the legislative foundations for it to at least become an option for pension provision.
As a result of the proposals in this year’s Budget, for many people defined contribution (DC) schemes will now operate purely as a retirement savings account, while the likelihood of employers opening new defined benefit (DB) schemes is slim. CDC has the potential to offer more generous and stable pension returns to scheme members and act as a viable alternative to both DC and DB schemes. The key benefit of CDC is that it strikes a more balanced share of responsibility for retirement saving between both the employer and the employee.
Today’s speech provides the opportunity for the development of some of the structures suggested in 2013’s November consultation paper ‘Reinvigorating Workplace Pensions’. Today’s outcomes also demonstrate the government’s commitment to creating space for CDC to develop as a credible option, and the legislative framework should come into effect in time for the consideration of schemes facing the end of DB contracting out.
Defined ambition is a difficult concept. While investment returns and life expectancy conform with expectations, the system brings some benefit. Outside these norms, as we have seen in Holland, the system breaks down. Defined benefit pensions depend on the corporate sponsor’s covenant, but for the majority have proved reliable. Annuities protect the individual from investment risk and living longer than expected. Defined ambition gives no such guarantee.
The government has been floating ideas about risk-sharing in pensions or ’defined ambition’ for some time now, so it’s good to see it come to fruition in the form of a Bill.
While these new-fangled pension schemes won’t be for everyone, they can work well in some situations. In principle they can deliver better outcomes for savers than conventional DC pension plans, but at the cost of some extra complexity. It remains to be seen how much appetite there is from employers/providers and savers alike; the market will take time to adapt to the new flexibility and whether for example mirroring the Dutch model is the right way to go. A key challenge for government will be balancing the regulatory requirements and ensuring savers understand the benefits and risks of such a scheme, but without strangling the whole idea at birth with red tape.
One slight disappointment is that flexibility to change benefits provided by defined benefit plans that were suggested in the consultation last year for existing defined benefit plans does not get a mention. This presumably means that they will not be pursued and that government has resigned itself to the long-term decline and eventual extinction of defined benefit in the private sector.
Also mentioned in the speech is a bill to facilitate the flexibility announced in the Budget, so that members have complete control over how to spend their pension savings. Crucially, we are waiting on the Treasury consultation process to find out whether this will be confined to defined contribution plans or whether we’ll get a level playing field for defined benefit schemes too.
At the centre of all the reforms being introduced by the government is a desire to improve value for money for pension savers. With more than eight million people set to start saving into a pension as a result of auto-enrolment, ensuring that their pension delivers on its promises is a must.
The government’s top priority should therefore be to address the things we know for certain have an impact on savers’ pension pots namely the level of contributions made, the charges imposed and the design and performance of the default fund. Get these fundamental things right, and savers will see a significant uplift in their income in retirement without the need for further complexity in scheme design.
While innovations such as collective DC schemes have been successful in Denmark and the Netherlands, both of these markets are highly unionised and have had mandatory or quasi-mandatory pension saving for many years.
The populations are relatively homogenous and the collective DC schemes operate on an occupational basis with people from similar professions sharing risk with one another – a much fairer approach than manual workers sharing risk with white collar workers.
The UK is a much more fragmented market and while changing legislation to allow these schemes could have merit, in many ways it feels as though we are running before we can walk.
Like it or not, UK companies have limited appetite for pension liabilities and consumers have limited interest in locking themselves up in risk-sharing arrangements. As the market grows and matures, this position might alter, but I think we have some distance to travel.
Over the last few years, the UK pensions market has undergone arguably some of the biggest changes in its history – with today’s announcement adding further diversity to the mix. This move is to be welcomed as it demonstrates further innovation and a genuine commitment to providing better consumer outcomes.
However, we need to ensure that rather than simply copying the Dutch model, we recognise the UK market poses different challenges and consider how we can learn from their mistakes. One possible solution is to look at ways in which we can adapt the CDC model by using areas of expertise where the UK is arguably a world leader such as individual underwriting of longevity risk that underpins the current enhanced annuity products.
As usual, the devil will be in the detail and we await further information as to how these product might operate in the UK market.
Experiences from abroad suggest CDC schemes can offer the opportunity to achieve better investment returns because of pooling and lower administrative costs, but as with other defined contribution products they do place pension risks with members alone, so they may not appeal to employers wishing to provide some greater guarantee. However, some large firms will see CDC as an advance on traditional defined contribution schemes and over time we envisage there will also be industry-wide and multi-employer scheme interest from smaller employers.
Our research in 2013 also showed employer support for DA legislative reforms that would permit flexible defined benefit schemes, enabling firms interested in offering employees a solid defined benefit guarantee into the future to so do. Unfortunately, with this flexibility now apparently ruled out for the foreseeable future, we can expect more private sector employers to close their existing defined benefit schemes to new and, increasingly, existing members and to make radical pension changes over the next two years to cap their pension liabilities.
The emphasis is noble – reducing risk and delivering better outcomes for pension savers. The reality is this could create distinct winners and losers. Potential losers include younger savers and the less well-off. On both cases a sustained period of low investment returns would mean these groups subsidising current and better-off retirees who are likely to live longer.
The muted reaction of employers is based in part on the Netherlands’ experience. There, employers have found themselves paying in extra money rather than face the industrial relations impact of benefits being reduced. Naturally, UK employers will be wary of this potential liability.
It’s not all bad news though – sharing risk means lower operating costs and access to different types of assets that savers can invest in. Infrastructure and other previously out-of-reach investments can boost diversification, lower risk and provide more stable returns. Ultimately, the future of defined ambition may be determined by how well its collectivism can be squared with the individualist approach granted by the Chancellor in March’s Budget.
It is a positive step that the government is looking to legislate to allow for collective pension schemes. For too long government regulation has stifled innovation and this change opens up the opportunity for the creation of new products. Pensions will no longer be pigeonholed into defined benefit or defined contribution. It will be interesting to see if employers want to offer these types of products to their employees.
While collective arrangements can lead to higher returns, the danger is that if not done carefully then they can create a false expectation of certainty. Who can predict what will happen in the next five years, let alone the next 20 or 30 years? We need to make sure that these schemes don’t over promise only to then under deliver.
The increased flexibility in the overall regulatory landscape has to be a welcome step forward and in the long term will make it easier for pension schemes to provide solutions that really help people in retirement.
We welcome the government’s aims to boost choice and flexibility in the pensions market and collective defined contribution schemes will play a part in this. These schemes are complex, so they are likely to be offered only by a few large employers keen to provide their employees with something more predictable than existing defined contribution schemes.
They have the potential to deliver more for savers, but equally they need to understand that even in retirement their pots could decrease because there are no individual controls over how pensions are drawn down. That’s why organisations need to explain clearly the terms to employees.
Although we welcome the spirit of collective defined contribution (CDC) and indeed, any change designed to improve and enhance member outcomes, there is a very real danger that employers and individuals are becoming overwhelmed with yet another announcement of major reforms.
These new schemes will take time to implement and will only work if sufficient scale is reached. However, the Dutch experience shows that CDC schemes are not necessarily suited to the behaviours of all generations within the workplace. Those belonging to Generations X and Y, for instance, are much more likely to move jobs than previous generations. This could have a knock-on impact on other reform proposals such as pot-follows-member. If large amounts of money leaves or indeed joins CDC schemes when people move jobs, then it may have a detrimental effect on the risk sharing benefits. Furthermore, depending on how the UK implements CDC, there is a danger of it offering little in the way of benefits to next-of-kin upon death – a significant proportion of an individual’s accrued fund value is kept within the scheme, which is one of the features of traditional annuities that was most disliked.
Most importantly, these reforms should not derail the government’s positive efforts around auto-enrolment. With a huge number of SMEs still to stage, although signs are encouraging, auto-enrolment is relatively untested as yet and the continued rapid pace of reform does not allow sufficient time for people and employers to fully understand their options. There needs to be a period of reflection and more education, otherwise we risk inertia.
Collective defined contribution (CDC) is sometimes presented as a magic wand that can make everyone better off in retirement, but the government has never been convinced of that. Instead, it hopes that CDC can make pensions less of a lottery, rather than making them bigger on average. That’s a worthwhile aim, but CDC will only succeed if people trust the black box that adjusts the value of their savings up or down. Unless employers believe they will, they won’t set up CDC schemes.
Claims that CDC can make everyone richer are based on the idea that pensioners’ savings could stay invested in equities rather than being used to buy annuities. But pensioners can do that anyway, especially since the Budget. The difference with CDC is that younger savers must ride to the rescue when markets disappoint, while some of the upside is kept back from pensioners when things go well. It’s easy for either side to conclude that they are not being treated fairly, particularly in a prolonged bull or bear market, making pensions an intergenerational battlefield.
Now that members of DC schemes have more alternatives to buying annuities, more may choose to hold assets such as equities for longer in the hope of generating a higher return. The riskiness of investments could be gradually reduced as people draw down their pensions, rather than in the run-up to retirement. If CDC improves outcomes, so would this, but retirees would have to decide whether they are happy to take more risk without intergenerational transfers fall back on.
Giving employees greater choice over what they do with their pension pots is to be welcomed, but it will be vitally important to ensure that people are made aware of the potential consequences of drawing down their pensions as they wish. Individuals need first and foremost to plan for a sustainable retirement, and avoid making decisions that could jeopardise their financial security when they stop working. It will therefore be important for savers to be given access to independent and objective advice before the point of retirement, so that they are well informed about the options available to them and how they stand to be affected.
Instead of saving into individual pots, today’s announcement means people could be able to pool their resources together. The theory being that the larger fund should allow greater protection from stock-market variations, while the shared costs should result in better net returns and higher levels of income overall. This latest change to the pensions landscape will likely be welcomed by savers due to the promise of greater protection and guarantees for pension pots.
However, collective saving could be only the start – the pensions industry may wish to consider taking the same principle of people contributing collectively for a better retirement and applying it to annuities. Although the 2014 Budget now offers DC savers far greater flexibility about how they take their pension pot, the lump sum at retirement will not be right for all. Many people will still want a secure income and as such annuities will continue to be an attractive choice. The collective buying power of a large group of pensioners seeking to drawdown their pot en masse may see individuals get better rates than they would have done if they had bought on their own.
We are supportive of anything that might improve retirement outcomes for members, but we are mindful that there is no magic bullet to overcome the more fundamental issue of under-saving.
Defined ambition is one idea that could help, but would require a significant shift in how pensions are provided and we don’t believe it could be delivered simply through incremental change. Careful thought would need to be given to how such a framework is delivered, noting that the Dutch have recently questioned the on-going suitability of their own collective DC system.
While we are supportive of the intent, there is a more urgent and important need to ensure automatic enrolment is successfully embedded, following a very positive start. A shift in thinking at this point, mid-way through the rollout of workplace DC pensions to employers, may only serve to undermine that positivity by creating further upheaval for employers.
Behind the headline grabbing comments, the devil is in the detail. To make CDC work requires scale. Otherwise the efficiency gains, both in terms of administration and investment, don’t arise. There are considerable vested interests in maintaining the status quo. For example, investment managers and insurers potentially make more money when they are negotiating charges with individuals rather than providing ‘bulk discounts’. The Association of British Insurers has already issued a blog entitled ’10 things you need to know about collective defined contribution’ which argues strongly against its introduction. Unless the government legislates to break through those vested interests, CDC isn’t going to fly.
There are also significant governance challenges. The Office of Fair Trading has already stated that Governance in the IDC market isn’t strong enough. CDC has all the Governance challenges of the IDC market and more – the monitoring of the performance of funds, the scaling back of benefits away from their targeted levels should investment returns not be as anticipated isn’t something the insurer should be overseeing. Independent governance is going to be a challenge if the gatekeepers to the funds are the providers themselves.
We cautiously welcome CDC as a potential way to help boost levels of employee engagement thanks to better predictability of outcomes. However, we believe this should also be possible through the proposed post-budget DC framework.
It is important that the potential promise of CDC doesn’t delay trustees and schemes from improving their current plans in the hope of better things to come. The investment industry has a critical role to play here, ensuring that it builds better solutions that give members the confidence to stay on course with their retirement savings.
On top of the myriad of pension changes still facing employers they will not thank the government for throwing this unexpected curve ball. It is difficult to see many employers being enthused about introducing yet another, and unfamiliar, pension arrangement. If the basic aim of these proposals is to get people saving, this added complication from the government could well end up being counterproductive.
While the collective defined contribution (CDC) announcement is eye-catching again, the devil will be in the detail. Will, for example, the 0.75% charge cap, which will apply to defined contribution schemes for auto-enrolment purposes, be applied to CDCs? Caution is also required when predicting the impact on the size of the eventual pension pot, returns are always subject to performance of the underlying investments and there is no guarantee for members they will receive their target pension. Investment volatility for members would undoubtedly be much reduced, but most of this will already be achieved by the pension reforms announced earlier this year at the Budget.
Additionally, there is a big question mark over whether employers would want them. Many employers have just gone through the time-consuming and costly process of putting in place auto-enrolment schemes. Whether these schemes become popular will would certainly depend on the amount of regulation around their introduction.
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