Now that the festive season is over, our attention can turn to a different form of giving and receiving through retirement savings. It is fitting that, at one of the most fiscally challenging times of year, attention is being drawn to a new system of retirement saving, but is it really the ‘best of both worlds’ between the Defined Contribution (DC) and Defined Benefit (DB) arrangements we know so well?
What is CDC?
A Collective Defined Contribution (CDC) arrangement would be money purchase in nature, as the contributions that the employer and employee pay are fixed. However, rather than members having individually attributable accounts, investments would be held collectively to provide a target level of income in retirement. The aim is that members could plan for a more certain, regular income in retirement, similar to that provided by DB arrangements, albeit that this would not be guaranteed.
Until recently, CDC has struggled to gain momentum in the UK market. However, Royal Mail are now leading the charge following discussions with their workers’ union, CWU, over the future of retirement savings, which concluded that CDC is the most appropriate answer. As a result of this interest, the DWP has opened consultation on how best to implement Royal Mail’s proposed arrangement.
What’s the big deal?
Over a member’s working lifetime, it’s difficult to see how CDC will result in better returns than traditional DC arrangements.
Yes, the risk return profile may differ at different ages but, at the aggregate level, overall returns can only be enhanced by taking greater investment risk and accepting the associated volatility.
We’ve all seen how volatile the funding of DB arrangements can be and how difficult this can be to understand. One big challenge with CDC will be helping members understand the potential volatility in the target benefits, and explaining why benefits have to be adjusted from time to time.
It’s possible that the volatility could be mitigated by some form of smoothing of returns or a ‘corridor’ of funding within which target benefits could remain unchanged. This is a topic raised in the consultation but we should heed the lessons from traditional withprofits systems of smoothing returns, which has proved challenging for many insurers, leading to conservative investment strategies.
Economies of scale have been cited as a benefit of CDC through lower investment charges, but this is achievable in traditional DC arrangements via the growing trend towards Master Trusts. Perhaps these economies would be greatest in the post retirement phase where, currently, most DC members have to make individual arrangements with relatively high charges.
Continuing the post retirement considerations, current DC arrangements require individuals to make guesses about their own life expectancy. Although life expectancy improvements have been slowing, many people underestimate their own longevity leading to them running out of money in retirement. CDC schemes would have the benefit that, although the target benefit level may vary, something would continue to be paid to members for life. Currently, this certainty can only be achieved by the purchase of an annuity which can appear an expensive option for members.
This sharing of longevity risk brings another source of volatility. If members die more quickly than expected, the remaining members’ benefits would be increased (and vice versa). To reduce this volatility, CDC would require very large numbers of members. The government’s intention is for the option of CDC schemes to be limited to employers of a sufficient scale, but it is not yet known what they consider this scale to be. An interesting option might be for Master Trust type arrangements to be set up on a CDC basis purely for retired members. This would make pooling of longevity risk available to employees of smaller companies.
Another point that must be considered carefully is how CDC arrangements will interact with the pension freedoms introduced in 2015.
Pension scheme members have been enjoying far more choice and flexibility in retirement since the changes were introduced, and it would likely not be appreciated if CDC arrangements were to restrict this level of choice which has been embraced by many.
However, choice creates the opportunity for selection by individuals, watering down the benefits of pooling longevity risk, but this could be mitigated in a post retirement only CDC arrangement through appropriate pricing of longevity risk at a more granular level, akin to Club Vita.
Lessons from afar
Although CDC arrangements may be new for UK retirement savings, they’re well established in other countries where CDC has been accused of intergenerational unfairness. For example, in the wake of poor investment returns, the target benefits may need to be reduced. This would have an immediate impact on someone already drawing their benefits whereas a mid career member has time for markets to recover so might never actually suffer the reduction. Are the older generations paying to support the savings of younger generations? It all averages out for long serving members who remain in the same CDC arrangement throughout their working and retired lives, but is this likely to be reality for the majority? This is something where the consultation is looking for feedback.
Whilst older generations have enjoyed secure, guaranteed benefits in retirement from DB arrangements, as these arrangements have closed down, the contributions paid by employers have generally also decreased to the more ‘commercially viable’ contribution rates typically paid into the pots of DC members. It has been widely stated that the retirement incomes likely to be received by these individuals will not be sufficient for their needs. CDC arrangements are a positive step towards companies being able to support their employees and allowing them to enjoy the retirement that they deserve in comfort, but only if the general levels of contributions paid starts to increase again. Given the current economic headwinds around the world, it will be interesting to see how many other employers have the desire to introduce CDC in place of existing DC arrangements. Any meaningful level of target benefit would surely require higher rates of contributions from both employers and members.
The best of both worlds?
+ Cost certainty
+ Income for life
+ Risk sharing
+ Cost effective
CDC seems to tick many boxes but also comes with its own challenges. It’s likely to appeal to only a small number of employers but perhaps has a wider role to play in the past retirement environment where cost effective pooling of longevity risk meets a clear market need.
Partner – Hymans Robertson