Simon Eagle of Willis Towers Watson says that, based on his work for Royal Mail, well-designed collective defined contribution (CDC) funds would be viable for some other UK employers too.
There is currently debate about whether CDC pensions would work for the UK. Pensions and financial inclusion minister Guy Opperman has said the government intends to legislate for CDC next year, and the Department for Work and Pensions (DWP) is about to consult the industry on how best to do it. However, CDC means different things to different people, and there is currently confusion about what CDC might be in a UK context.
The main reference point are the existing CDC regimes in the Netherlands and parts of Canada. However, in both of those cases, CDC initially arose for benefits that had been treated as defined benefit (DB), and this constrained the CDC design. Current considerations for CDC in the UK are for future service only, and so a purer form of CDC could be possible for the UK.
CDC comes with perceived risks and challenges, so why would a UK employer bother? First of all, to be preferred to DB, CDC legislation would need to ensure that CDC really is defined contribution (DC), with fixed costs and no pensions on the balance sheet under IAS19 and UK GAAP.
When employers close DB schemes, the established path is currently to provide employees with individual DC pots, and many employers will continue to choose to do that. However, some will be attracted by the advantages of CDC:
- Provision of an 'income for life' - rather than a retirement pot
- Higher pensions - expected average CDC pensions are higher than from buying an annuity through an individual DC account, primarily through the ability to hold growth assets over a longer term.
- Steadier retirement planning - asset price volatility is naturally dampened, as it is reflected by adjusting pension increase levels.
- Longevity pooling - unlike drawdown, the individual's 'risk' of needing a pension over a longer life is pooled across members.
CDC risk sharing, which makes the above possible, also creates challenges, most notably that the resulting variations in pensions must be demonstrably fair to those members who share the risk. And this is where much of the CDC debate lies.
Can CDC design be fair for the members? Based on our work for Royal Mail, we believe so.
A good way of looking at fairness for CDC design is through an economic-prosperity lens - when times are good, many people in society benefit, and that is their good fortune. A CDC fund that invests in the global economy also behaves like this, and although the economic experience is partly shared over time, some generations still do better than others. That is luck, rather than unfairness.
So, if the pension accumulation rate is stable (eg 1/80th), and the mechanism for determining the increases is fair, then the challenge is met. How can this be achieved?
- No bias towards one generation over another. This means a number of requirements:
- No capital buffers / prudence reserves, so that money the fund can afford to pay out to the current generation is not held back for future generations.
- Each year, members of all ages get the same increase (or cut).
- CDC design cannot depend on a continual stream of new contributions - if a CDC fund ever closed to new accrual, pension increases for the last generation should not be adversely affected. This requires the CDC fund to plan for some low-risk assets to back pensions in payment, so that, even many years after closure to accrual, a CDC fund that ran on would still be paying relatively stable pensions with similar expected increase rates.
- A robust governance structure. One way to achieve this is to minimise operational discretions. The method used to determine pension increases, and key aspects of the investment strategy, would be set in the rules when the CDC fund is opened. There will always need to be judgement somewhere, and this lies in the actuarial assumptions used to determine the sustainable increase rate. It can be prescribed that the actuary's assumptions must be their 'central estimate' of the future - subject to benchmarking against others in the industry where appropriate, to ensure credibility.
Members will need to understand that lower increases, or even pension cuts, are possible, and accept that. Just as they are for individual DC schemes, member communications about variability will be important.
Inevitably, more details of how CDC could work in practice in the UK will be drawn out as part of the DWP's imminent consultation. However, from our work, we believe that a well-designed CDC fund will be a new, viable option for UK employers, which some will see as the best one for their employees.
Simon Eagle is a director at Willis Towers Watson. He has been advising Royal Mail on CDC design and is also looking at wider applications of CDC
