2Arguments for and against CDC
9.In this chapter we examine the merits of enabling CDC pensions in the UK. We consider:
- the potential benefits for scheme members, employers and the wider economy; and
- whether CDC can be incorporated coherently into the UK pensions system.
Potential benefits
Benefits for members
10.Proponents of CDC argue that it can deliver higher retirement incomes for the same level of contributions as individual DC. The main reasons why CDC may produce better pensions are:23
- Longevity pooling: individuals cannot accurately predict how long they will live. Left to manage their own retirement funds, they must effectively act as amateur actuaries on their own behalf and are at risk of underspending (dying with funds unused) or overspending (running out of money). Pooling enables the efficient collective management of this risk, harnessing the “magic of averages” to pay a lifelong income to all members.24 In this way, CDC mimics the key benefit of an annuity—the assurance of a regular income for life—without the cost of covering the insurer’s capital buffer and profit margin.25
- Investment outlook: CDC investment strategy can be longer term and less defensive than in standard DC saving. A DC pension pot is typically de-risked (by shifting investment from riskier equities to safer bonds) in the years leading up to retirement.26 This is to protect the individual against the risk of a sudden fall in their pot value at the point of retirement. CDC, however, can keep funds collectively invested in a balanced, return-seeking portfolio of assets for the long term.27
Removing the need to purchase a separate retirement income product may also reduce cost leakage to third-party providers and advisors.28
11.Various studies have attempted to model the potential benefits of CDC for scheme members. In 2013, Aon, an insurance company, found that the median outcome for CDC savers was one-third better (a pension of 28% of final salary compared to 21%) compared to individual DC pots that were de-risked and then invested in an annuity.29 Other studies have showed improvements of similar magnitude: a 2009 Government Actuary’s Department (GAD) study found that the median improvement in outcome offered by CDC “is as high as 39% for some members.”30 A 2012 paper by the Royal Society of Arts (RSA) indicated a 37% boost to outcomes through CDC.31
12.Those studies were all carried out before the pension freedoms reforms and assumed the saver would purchase an annuity at retirement. Since 2015, individuals have had greater freedom to choose drawdown or withdraw cash instead. Reflecting the new policy context, the Department for Work and Pensions (DWP) commissioned a study by the Pensions Policy Institute (PPI) which compared a CDC scheme similar to that modelled by Aon with various individual DC alternatives. This study found that CDC outperformed individual DC in terms of average income replacement rate in almost all the modelled scenarios. Outcomes for an individual DC pensioner adopting an “aggressive” drawdown approach of withdrawing 7% of their pot each year compared favourably with CDC at the outset, but carried a heightened risk of funds running out before death.32
13.CDC also promises less volatile outcomes between cohorts of members compared to individual DC. Even with de-risking investment strategies, the pots available to individuals in DC are dependent on highly unpredictable market performance in the period leading up to retirement. Market volatility can lead to very different outcomes for individuals with otherwise identical circumstances retiring only a few years apart.33 The 2013 Aon study showed pensions for individual DC savers ranged from around 10% to 60% of pre-retirement income depending the year in which they happened to retire.34 CDC, by contrast, delivered smoother, less volatile outcomes for successive cohorts of pensioners.35 This greater predictability may well be considered both more desirable and more equitable by savers.36
Figure 1: Aon modelling indicated that CDC could deliver less volatility and a better median outcome than individual DC
Source: Aon (2013), Collective defined contribution plans - a new opportunity for UK pensions?
14.The analyses cited above are based on assumption-based modelling rather than real world data.37 The Pensions and Lifetime Savings Association (PLSA), an industry body and NEST, a major DC scheme set up by the Government, both told us that real-world CDC schemes tend to invest more cautiously than assumed in theoretical modelling. They argued that large-scale DC schemes can enjoy similar investment benefits to CDC.38 Capital Cranfield, a professional trustee and governance firm, said however that:
even if CDC does not offer significantly better benefits than DC it is unlikely to result in worse benefits overall and is therefore definitely worth considering further.39
Benefits for employers
15.The decline of DB pension schemes primarily reflects desire among employers to reduce their pension costs and potential liabilities.40 These costs can be very substantial. In the year to 31 March 2018, defined benefit scheme sponsors made £13.5 billion in special payments in addition to their regular annual contributions.41 As the risk of a CDC scheme being underfunded falls on scheme members rather than a sponsoring company, CDC carries the same benefit to employers as standard DC.
16.We heard that there are other potential benefits of CDC for employers:
- Offering an attractive pension package may help them recruit and retain employees. APG Group, a major pension administrator and fund manager in the Netherlands, said research suggests that workers who can look forward to “more secure” retirement benefits may be more productive.42
- By providing greater predictability of outcomes compared with DC, CDC may reduce the likelihood of people needing to work beyond their preferred retirement date. This was identified as a risk to both savers and employers, with small and medium-sized businesses particularly concerned.43
- Employers may see it as their duty to help their employees achieve a decent pension.44
Benefits for the wider economy
17.We also heard that CDC may bring investment benefits to the wider economy. The long-term investment horizon and size of potential CDC schemes could enable them to invest in long-term assets. These might include providing capital for infrastructure projects or investing in innovative firms.45 In turn, this could increase the productive capacity of the economy. The RSA pointed to the “much larger allocation to infrastructure of Dutch pension funds” compared with their UK counterparts.46 Such benefits would be in keeping with the Government’s desire to increase the supply of “patient capital” to the economy.47
Coherence with the UK pension system
Is it compatible with pension freedoms?
18.Several witnesses questioned whether the collective pooling of savings and risk characteristic in CDC was compatible with pension freedoms.48 The Association of British Insurers (ABI), an industry body that represents annuity and drawdown providers, said that CDC may be seen as “a backward step” by “savers who value the flexibility of DC and are coming round to the idea of owning their own pension”.49
19.In theory, individual CDC members could have rights to their own distinct pension within the scheme, which they could transfer out if they chose. This could increase the likelihood of selection bias in scheme membership: members who expect to die young would have an incentive to transfer out of the CDC scheme, leaving the membership skewed towards people with long life expectancies, who are expensive to the scheme.50 Some of the benefits of longevity pooling, which are greatest when there is a diversity of life expectancies in the pool, are lost.51 Furthermore, CDC schemes would have to incorporate demand for transfers out into their approach to their funding position and investment strategy.52 For example, they would need to hold sufficient liquid assets to accommodate possible transfers out.53 The PLSA said that, while CDC could fit within the broader setting of pension freedoms, it would be “an imperfect match”.54
20.It is already the case, however, that members of DB pension schemes—further removed from DC than CDC—can transfer their pensions out. The Communication Workers Union (CWU) told us there was “ample scope” for incorporating flexibility and freedom in CDC.55 Kevin Wesbroom, consulting actuary at Aon, told us that transfer values could be calculated, “balancing the interests of the member who is leaving with the members who are remaining”.56 Indeed, it is conceivable that savers seeking a regular income in retirement could be allowed to transfer in to a CDC scheme.57 Rather than being incompatible with pension freedoms, CDC is arguably completely consistent with it—it is an attractive choice for people seeking a regular pension in a low interest era in which DB pensions are in decline. Philip Bennett, a former partner at law firm Slaughter and May and an expert on CDC, said that CDC “enhances individual freedom and choice by providing an additional way of providing retirement income for individuals”.58
Is CDC too confusing?
21.We heard concerns that introducing CDC would “create more complexity in an already complex market”.59 These focused on concerns that members would fail to understand that they, rather than their employer, bore the funding risk in CDC and would feel cheated if they faced reductions in indexation or pensions in payment. This could result in loss of trust in the system.60
22.The highest profile example of CDC schemes having to scale back their payments to pensioners was in the Netherlands, where scheme funding levels were severely affected by the 2008–09 financial crisis and subsequent recession. Having had no previous experience of cuts to their pension entitlements, members had come to see them as guaranteed and viewed the cuts with “considerable understandable dissatisfaction”.61 Despite the severity of the financial downturn, however, the reductions were relatively limited. Fewer than a quarter of schemes with recovery plans applied reductions, and the average reduction in these schemes was 1.9% in 2013 and 0.8% in 2014.62 Those reductions compare favourably with changes in the cost of buying an annuity over the same period, and, unlike a fixed-income annuity, a reduced CDC income can be increased if economic conditions improve.63 The reductions in the Netherlands also compare favourably with those for UK DB schemes that fall into the PPF, in which members not yet of pension age face 10% cuts to their starting entitlement.64
23.Other witnesses told us that CDC could alleviate existing complexity around pensions.65 While many savers have welcomed the opportunity to consider the range of drawdown and cash withdrawal options at retirement, for others the decision is confusing and risky.66 The Trades Union Congress (TUC) said that, given the pension options currently on offer “are not well understood” by many savers, CDC would “reduce current complexity”.67 The Association of Member-Nominated Trustees suggested that arguments that CDC would add unhelpful complexity to the system may come from “from people who are well served by providing the status quo”.68
24.Crucially, CDC would combine the accumulation (saving) and decumulation (income) phases of a pension, providing both a savings vehicle and a regular retirement income.69 In our report on pension freedoms, we argued that philosophical coherence in pensions policy would mean giving savers a simple, default decumulation option on retirement consistent with default accumulation in automatic enrolment.70 The RSA told us that by meeting the “acute need” for such a default, CDC would serve as a “perfect complement” to pension freedoms.71 The CWU said that the prospect of a clear target income in CDC would enable scheme members to plan better for the future and would increase confidence in saving.72 The PLSA welcomed “the unambiguous focus that CDC places on the provision of an income”73 which research has found is the priority consideration for savers accessing the pension freedoms.74
Why now?
25.Notwithstanding the potential advantages of CDC, we considered whether it was the right time to enable its introduction given major pension reforms such as automatic enrolment are still bedding in.75 The Minister told us that the focus of the DWP “is on accumulation” and that decisions about decumulation, “of which CDC may be a part”, are for a future date.76 The saving and income phases of a pension are, however, mutually dependent. The CWU said that the prospect of a regular and predictable income through CDC could increase confidence in saving.77 Rather than undermine the accumulation of pension savings, the introduction of desirable pension income options could promote greater participation.
Is CDC counter-cultural?
26.KPMG, a professional services firm, cautioned that the success of CDC in other countries “is as dependent on the social and labour market context in those countries as much as their legal and regulatory framework”.78 The Association of Consulting Actuaries echoed this, arguing that there is “no tradition in the UK of risk-sharing between pension scheme members” and that UK culture favoured “personal choice over social provision”.79 NOW:Pensions is a DC pension provider in the UK, but its Danish parent company ATP provides CDC pensions to nearly 5 million Danes. NOW:Pensions highlighted numerous cultural and structural differences between the UK and countries where CDC has been successful:
Denmark and the Netherlands are both highly unionised countries, and have had mandatory or quasi-mandatory pension saving, with high levels of contributions, for many years. Crucially, they also already have big CDC arrangements in place. The UK on the other hand has a more fragmented workforce.80
27.While the UK does not have a history of CDC, it does have a tradition of collective pensions in the form of DB. DB schemes are relatively concentrated in longstanding companies with higher rates of unionisation. CDC in the UK may well be particularly attractive to large employers, especially those looking to close their DB schemes and find for their workers superior pension provision to individual DC.81 We therefore considered whether there is evidence of demand for CDC.
Is there demand for CDC?
28.The Confederation of British Industry (CBI) told us:
whilst the potential benefits of CDC pensions are evident, so too are the potential risks and there is not yet a clear picture of the appetite amongst employers to offer such schemes.82
The RSA told us, however, that “big companies, especially those closing DB plans [ … ] have lobbied for change behind the scenes.”83 The Society of Pension Professionals told us that when the Pensions Act 2015 was under consideration there were around 10–20 large employers “with a serious interest in developing this type of provision”.84
29.Soon after we launched our inquiry, Royal Mail became the UK first company to commit itself publicly to CDC pensions. Royal Mail told us that, for industrial relations reasons, it had been unable to declare its interest in CDC sooner. Closing DB schemes was “very sensitive” and companies would risk “worrying their workforce” if they speculated about potential replacements. Royal Mail said that they believed there would be other companies privately considering CDC and that the absence of public expressions of interest should not be interpreted as indicating an absence of “significant latent demand” from businesses.85
30.We heard that there is also interest in CDC from pension schemes. The RSA told us that in the lead-up to the Pension Schemes Act 2015 they “took a delegation of eight pension funds to see the Minister privately” to argue for the introduction of CDC”.86 The PLSA said that “a group of large schemes and master trusts that see the potential for pooled decumulation products”, particularly as a potential replacement for annuities.87 Philip Bennett concurred that CDC could be attractive to NEST and other large DC schemes”.88
31.The full extent and nature of demand for CDC will only become apparent once the regulatory framework is established. It currently remains “largely a theoretical concept” for which it is difficult to gauge demand.89 Robin Ellison, a pensions lawyer and trustee, suggested that “many employers are keen to explore [CDC] when made aware of the possibility” but that few employers have the resources to turn theoretical options into practical proposals.90 Mark Rowlinson, an actuary, told us “if you build it, they will come”.91
Conclusion
32.Through the pooling of risk, CDC offers scheme members the potential for better pensions than from standard defined contribution saving. It may be particularly appealing to people who desire a regular and reliable income in retirement. For employers keen to offer their workers decent pensions but reluctant to take on large potential liabilities, CDC is an attractive alternative to defined benefit schemes. CDC would therefore be a good choice for some employers and some savers that addresses limitations in their current options. To offer more good choices is entirely consistent with pension freedoms.
33.While the Government has rightly emphasised, and succeeded in, ensuring more people save for retirement, that focus should not preclude enabling new models of pension provision. The job of selling the benefits of retirement saving is made easier if the saver has a desirable pension to look forward to. Impetus for enabling CDC schemes in the UK has been increased by the agreement to seek to introduce one for Royal Mail. We consider the Royal Mail proposals in the next chapter.
24 HC Deb 25 May 1911 vol 26 col 509 [Winston Churchill, 2nd Reading of the National Insurance Bill 1911]
27 Written evidence from KPMG LLP (CDC0016) para 9.6, First Actuarial (CDC0018) Barnett Waddingham LLP (CDC0031) para 8, Philip Bennett (CDC0043) para 3.4,
28 Written evidence from Mark Rowlinson (CDC0039), Barnett Waddingham (CDC0031) para 9, and the Association of Member Nominated Trustees (CDC0032)
29 Aon (Nov 2013) The Case for Collective DC: A new opportunity for UK pensions; also cited in RSA (Nov 2013) Collective Pensions in the UK II: Now is the time to act. Aon modelled successive cohorts of pensioners who had contributed 10% of pay over 25 years, over a 57-year timescale.
30 Government Actuary’s Department (GAD, Dec 2009) Modelling Collective Defined Contribution Schemes: a summary of The Government Actuary’s Department modelling of collective defined contribution schemes
31 RSA (July 2012) Collective Pensions in the UK
32 Pensions Policy Institute (PPI, Nov 2015) Modelling Collective Defined Contribution Schemes
35 The PPI and GAD studies made similar findings.
41 ONS Investment by insurance companies, pension funds and trusts (MQ5), table 4.3 Self-administered pension funds income and expenditure (21 June 2018 release)
43 Written evidence from Philip Bennett (CDC0043) para 2.4, Association of Consulting Actuaries (CDC0027), B&CE Ltd (CDC0041), Q28 (Hilary Salt)
45 Written evidence from the Department for Work and Pensions (CDC0029), PLSA (CDC0017), the Pensions Institute at Cass Business School (CDC0014, APG (CDC0010), Mark Rowlinson (CDC0039), Association of Member Nominated Trustees (CDC0032), TUC (CDC0019)
47 HM Treasury, Autumn Budget 2017 HC 587 (2017–19) page 49 box 4.1
48 Written evidence from NOW:Pensions (CDC0025); the Pensions Institute at Cass Business School (CDC0014) para 7
50 People who know they have short life expectancies may of course choose not to join a CDC scheme in the first place.
55 Written evidence from the Communication Workers’ Union (CDC0023) para 26. See also written evidence from Philip Bennett (CDC0043).
60 Written evidence from Hargreaves Lansdown (CDC0002), Pension and Lifetime Savings Association (CDC0017)
62 DNB assesses pension funds’ recovery plan evaluations, De Nederlandsche Bank (DNB) press release, 25 April 2013; DNB completes its assessment of pension funds’ recovery plan evaluations, DNB press release 1 May 2014
63 Written evidence from Association of Member Nominated Trustees (CDC0032) and Barnett Waddingham LLP (CDC0031)
64 Pension Protection Fund website - Compensation (accessed June 2018)
65 Written evidence from B&CE Ltd (CDC0041), the RSA (CDC0009), Royal Mail Group (CDC0033), Redington (CDC0030), Association of Member Nominated Trustees (CDC0032)
70 Work and Pensions Committee, Ninth Report of Session 2017–19, Pension Freedoms, HC 917, paras 11 and 22
73 Written evidence from the Pensions and Lifetime Savings Association (CDC0017); see also written evidence from Philip Bennett (CDC0043) para 3.2.
74 NAPF (Aug 2015) Pension Freedoms: Breaking the deadlock Understanding Retirement: Wave II Interim Report
75 Written evidence from the Association of British Insurers (CDC0038) para 25, Now:Pensions (CDC0025)
77 Written evidence from the Communication Workers’ Union (CDC0023) para 31. See also written evidence from the Trades Union Congress (CDC0019).
90 “Pension innovations should be optional”, Letter from Robin Ellison to the Financial Times, 8 May 2018
Published: 16 July 2018