These schemes retain some of the benefits of DB and DC, while addressing the downsides of each
The Pension Schemes Act 2015 introduced the concept of collective benefits. Under pension schemes providing such benefits, a member’s retirement income is determined by the total value of the assets held by the scheme at the point of retirement, the factors used by the scheme to identify the member’s share of the fund and the method used to turn the member’s share into income.
In October 2015, however, the government announced implementation would be postponed indefinitely.
Collective benefits are now back in the spotlight following a pioneering agreement between Royal Mail and the Communication Workers Union to pursue the creation of a collective defined contribution pension scheme for all employees of the company. The business announced in April 2017 it would close its defined benefit scheme to all new accruals from 31 March 2018, to be succeeded by an improved DC plan.
Discussions between the company and the union followed, culminating in February last year with the aforementioned agreement. Proposals for such a scheme received a positive response from the government. This was followed by the work and pensions committee’s report on CDC pensions published on 16 July. The report praised the effort of Royal Mail and the CWU as it created an opportunity to make such pensions a practical reality. The fundamentals of CDC pensions are:
Collective: the longevity, investment and inflation risks in the scheme are shared collectively among the members, rather than being borne individually;
Defined contribution: the respective contributions of employee and employer are defined in advance, with no ongoing liability to pay more to cover deficits.
Benefits and drawbacks
CDC schemes provide target rather than promised benefits, with any underfunding of the pension target addressed through reducing benefits. They retain some of the benefits of DB and DC pensions, while addressing the downsides of each. The report claimed studies conducted by various groups indicated CDC could deliver higher retirement incomes for the same level of contributions as individual DC. The higher incomes are achieved through a combination of a less defensive investment strategy than DC and the mortality cross-subsidy that exists when income is taken.
For employers, because the risks are carried by the scheme membership, CDC presents the same benefits as DC. In addition, the potential for CDC pensions to provide a better income for members in retirement could help employers to attract and retain staff.
The downside of CDC pensions is that they might add complexity to an already complicated market and be incompatible with pension freedoms. Intergenerational fairness is a major issue for CDC pension schemes. The success of such schemes will rely on people perceiving that they will be fairly rewarded for the contributions they make at every stage of their working life. The report urged the government to address this issue as part of consultations.
The report concluded that there was an opportunity for the government to encourage innovation and the great potential gains by establishing a framework for collective pensions in the UK.
Reviving and sustaining company pensions for generations to come can be achieved while still offering individuals freedom and choice.
In response to the report, the government published a consultation paper on 6 November, which closed last week. This set out proposals as to how a particular form of CDC scheme might work in the UK, and the legislative and regulatory regime that would be needed to support any such scheme.
It gives an indication of the government’s policy intentions and likely focus of the legislation.
Solving a dilemma
The move from DB to DC in the workplace pensions arena continues apace. The resulting transfer of risk from employer to employee could be viewed as a deterrent to saving for retirement, particularly for those on low incomes. Despite auto-enrolment, it is widely agreed people are not saving enough for retirement.
Pension freedoms provide individuals with more choice. However, making the appropriate choice of retirement income product is also more difficult. The dilemma for those who are risk-averse is that they either accept the riskier income product or opt for an annuity, with the perceived lack of value it offers.
An option that sits somewhere between the two, while offering the potential for higher income, could go some way towards delivering a solution to this dilemma.
Whether the claims made in the report will be borne out in practice will depend on the quality of the new legislation, and the engagement of employers, employees and their representatives. More so, predicting whether CDC schemes will become a feature of the UK pensions landscape is difficult given these politically uncertain times.
Neil MacGillivray is head of technical support at James Hay