Everything you need to know about CDC pensions
Collective Defined Contribution (CDC) schemes could increase pension pots by up to 30%. But are they right for the UK market?
With auto-enrolment only just behind many organisations (and lots of smaller companies still to stage), is the next pensions revolution already around the corner? Headlines about collective defined contribution (CDC) schemes appear to suggest it might be. Do HR professionals need to prepare themselves for yet more pensions trauma?
Luckily, not quite. The good news is that, while CDCs could provide a useful future option, the matter is nowhere near as pressing as auto-enrolment, this year’s dramatic Budget pension changes, the charge cap and new governance and disclosure requirements.
However, HR departments do need to familiarise themselves with the main issues surrounding CDCs in case they are asked about them by employees or are discussing future employee benefits strategy with finance functions. So, HR magazine has compiled a handy guide to everything you need to know about CDCs.
Proposals to introduce CDCs in the UK have resulted from pensions minister Steve Webb’s ‘defined ambition’ programme to provide a halfway house between defined benefit (DB) and defined contribution (DC) schemes.
CDCs, which already exist in the Netherlands, Denmark and certain parts of Canada, offer employees the chance to enjoy a pension income based on a notional perception of final salary. But, unlike with DB schemes, this is not actually guaranteed. Employees take the investment risk but they can enjoy significantly higher returns than from a standard DC pension. This is because of the investment flexibility and lower charges resulting from having their money pooled together with that of many other people’s, and because their pension income is paid from a fully invested fund rather than from an annuity.
Traditional DC schemes invest money until retirement, but CDCs invest until death and can smooth returns like a with-profits plan (which share in the profits of the fund). If one group of workers hasn’t done well the trustees can cross-subsidise them from others.
Three studies carried out during the past five years have found that CDCs can achieve returns of 30% to 40% higher than standard
DC schemes. The Government Actuary’s Department found they can achieve an upside of 39%, Royal Society for the encouragement of Arts, Manufactures and Commerce (RSA) found an upside of 37%, and Aon Hewitt reported an upside of 33%.
“The results are pretty consistent,” says David Pitt-Watson, executive fellow at London Business School. “The most important elements are that you don’t have to buy annuities and that it’s easier to invest in more relevant assets.
“There’s very broad support among consumers, but not so much among the pensions providers, who refer to the fact that they have a way of doing things in the UK and would like this to continue,” he adds. “But the change isn’t forcing anyone to do anything, it’s just providing a legal framework in case they want to in future.”
A recent government response to a four-month consultation on pensions changes has emphasised flexibility for savers. The National Association of Pension Funds (NAPF) anticipates enabling legislation that is not overly prescriptive and should allow various forms of these schemes to be developed.
The changes will be included in the Private Pensions Bill, which is likely to go through parliament next year concurrently with the Pensions Tax Bill that includes the Budget changes. The possibility of a Labour government should not upset the applecart because although Labour had originally considered and rejected CDCs when last in office, it now supports the concept.
What are the problems?
Opponents of CDCs point out that all the research showing enhanced returns of over 30% took place before the recent Budget changes, which have removed the requirement for people to take an annuity. Therefore, the enhanced performance could now be significantly lower, although the approach would involve far less hassle than income drawdown.
They also home in on the fact that in the Netherlands pension incomes from CDCs have reduced during the past two years.
However, as Pitt-Watson explains, these reductions were very unusual, averaged only 2% (with a maximum of 6%), and have already been restored.
Another commonly cited reservation is the differences in cultures and existing pensions structures between the UK and those countries already operating CDCs. The Netherlands, for example, is highly unionised and if there is an industry-wide scheme then employers must normally join it.
The Dutch have also converted existing DB schemes into CDCs, but UK rules do not permit this.
Experts commonly predict that CDCs in the UK will be of far more interest to employers coming out of DB schemes and wanting to go halfway to a DC scheme than to those who already have DC schemes and don’t want to return to taking more risk. The extra costs involved with having to start CDCs from scratch could deter any interested parties.
Kate Smith, regulatory strategy manager at Aegon, whose parent company operates CDCs in the Netherlands, says there are actually some “highly technical differences” between the CDC Steve Webb describes and those currently offered in the Netherlands.
“Unlike in the UK, there is also a general acceptance in the Netherlands of the practice of one generation subsidising another, although the young there are beginning to make noises against it,” she adds.
Perhaps the greatest barrier of all, however, is a lack of interest on the part of UK providers in getting involved with CDCs. The fact that the approach is so similar to with-profits, which saw many insurers get their fingers burnt, probably doesn’t help either.
The most commonly cited reason for non-participation is that providers already have so much on their plates with compulsory pension changes and CDCs will only be a voluntary option. Lack of employer demand is also flagged.
Jamie Jenkins, head of workplace strategy at Standard Life, says CDC is not on his agenda yet. “On the face of it as a company we are very well prepared for offering CDCs as we have investment houses, admin platforms and scale,” he explains. “But we don’t have any demand from employers, and you’re not going to do product development on the basis of no demand. So, although it’s an interesting idea, it’s not a priority.” Even those overseas insurers who are already involved in CDCs hardly seem to be chomping at the bit to enter the UK market.
Morten Nilsson, chief executive of NOW: Pensions, whose parent company ATP offers a form of CDC in Denmark, says neither NOW: Pensions or ATP have been very supportive of CDCs for the UK.
“In Denmark the concept works very well as the size of schemes there can drive down the cost base, and the country is heavily driven by unions and has industry-wide pension funds containing all workers in particular sectors,” he adds. “Because these people have similar incomes and lifestyles, there are similarities from the longevity point of view and less cross-subsidisation than there would need to be in the UK.”
Is anyone interested?
Kevin Wesbroom, senior partner at Aon Hewitt, feels CDCs will be attractive to three particular categories of UK organisation. These include large employers with more than 5,000 employees, of which Aon Hewitt already has two or three “fairly hot prospects”; Dutch-style industry-wide arrangements involving unions, charities and affinity groups; and master trust arrangements using pooled funds from various different schemes.
Nevertheless, most who forecast interest in CDCs do not anticipate it really occurring for several years, after providers and employers have finished dealing with the current raft of mandatory reforms and pensions schemes have built up some scale through auto-enrolment.
Will Aitken, a senior consultant at Towers Watson, believes a rush of demand is unlikely.
“Judging by what Steve Webb has said, I think he’s realistic about the fact that there isn’t going to be any huge demand overnight, but that there might be in five or 10 years’ time,” he says.
“I feel there can be a place for CDCs but you need a reasonable degree of certainty about demographics being the same in the future, so some industries might be more bullish about its prospects than others.
“You need an industry where things will still be the same in 100 years’ time, otherwise there could be no new blood to follow older generations and you might be left with a Ponzi scheme with older members holding all the risk and potentially not being compensated.
Aitken says a scheme will need “tens of thousands of employees to be cost effective” and, therefore, doesn’t see it becoming mainstream. He adds: “But I could see it happening at the margins, with possibly two or three big schemes.”
However, even if HR directors in very large organisations start to appreciate the advantages that CDCs may be able to offer employees over standard DCs, they may well find themselves at loggerheads with finance directors who are concerned at the substantial implementation costs.