It seems there’s never a dull moment in pensions these days, although to some people, consolidation, new regulatory powers and GMP equalisation might not sound enthralling. Now, the DWP has announced a consultation on Collective Defined Contribution (CDC) schemes.
Why has CDC appeared on the scene?
The Pensions Freedoms heralded a shift away from annuities, towards taking drawdown without advice.“Twice as many pots have been used for drawdown than to buy an annuity”, according to the Financial Conduct Authority (FCA). Very low interest rates have created two key challenges for Defined Contribution (DC) scheme members:
The challenges with the so-called decumulation phase, in particular, means that many Defined Contribution (DC) members are playing ‘amateur actuaries’ and run the risk of running out of money.
The Collective Defined Contribution (CDC) scheme aims to address these challenges by pooling risks amongst members. The Department of Work & Pensions (DWP) consultation focusses on a specific form of CDC for Royal Mail, where contributions will go towards a “target benefit” of 1/80th of salary each year, funded on ‘best estimate’ assumptions. Importantly, CDC members’ benefits aren’t guaranteed.
A fine balancing act
In an individual DC pot, members tend to dial down their investment risk exposure as they approach and move to retirement. But the idea behind CDC schemes is that by pooling risk, you can underwrite target benefits by investing in more risky assets. A key challenge of a CDC scheme is management of the investment and longevity risks.
It’s a bit like walking a tightrope: whilst it’s not impossible, it can be tricky. You have to respond quite quickly to events around you, else you risk a fall. So the CDC scheme will carry out annual funding valuations. The scheme will not apply any ‘buffer’ to smooth investment returns – it will immediately adjust all members’ benefits, up or down, accordingly.
Lessons from with-profits policies and especially from Equitable Life, tell us that managing and responding to events is key. I believe strongly, that the authorisation process and annual valuations include stress testing, which would involve closure and lower investment return scenarios. The outcomes of the annual valuation and stress testing must also be shared with members in a transparent manner.
Communications: Awfully simple, or simply awful?
Many members have a good understanding of how pensions work, but far too many don’t.
A second important challenge to CDC will be to explain clearly how it works. Easier said than done. Benefits that can increase or reduce from year-to-year are new territory for the UK. In CDC, there will be little time to delay or soften bad news and mismanaging the communications to members would have severe consequences. But, if you can crack this nut, then I think it is tremendous progress.
So will CDC catch on?
I applaud innovations that seek to improve the outcomes for members. While this consultation appears to focus on a specific form of CDC for Royal Mail, I’m not sure that it will have broader appeal just yet, until this type of arrangement and its risks are better understood. Companies with open defined benefit arrangements looking at reform must certainly consider this consultation carefully.
I certainly believe that members struggle with decumulation and it’s a bit of a shame that the consultation misses the opportunity to grasp this nettle. I hope this consultation is a spring board for further innovation in the design of savings vehicles that cater for a rapidly changing world.
For further information, please contact Scott Kendrick.