Can CDC help fix a ‘broken’ DC system?

The Department for Work and Pensions opened its consultation yesterday, calling for input on the proposed rulebook for multi-employer CDC schemes.

Willis Towers Watson (WTW) – in a report titled ‘Reimagining pensions’ – has called on employers to look beyond just repairing “broken” defined contribution (DC) pension provision.

It set out four ways of replacing DC pensions with designs that could help employees achieve better outcomes, without employers having to shoulder the risks associated with traditional defined benefit (DB) plans.

The models included a whole-of-life CDC approach, as chosen by Royal Mail for its new scheme. Other options included DB with variable increases to introduce an element of risk-sharing, and allowing traditional DC savers to buy into a CDC retirement model that pools investment and longevity risks.

The fourth option proposed was a variable cash balance with CDC in decumulation.

Rash Bhabra, head of WTW’s retirement practice in the UK, said: “With every year that passes, employees in most of the private sector are becoming more reliant on DC pensions to satisfy their income needs in retirement.

“DC can be made better, and there is rightly a lot of attention on this, beyond just increasing contributions: schemes can be bigger and more efficient; they can invest more widely and hold growth assets for longer; and they can give employees much more support at retirement. We welcome the sense of urgency on this.

“But we should also ask whether we can do better than DC: in its current form, DC is broken, and we should consider whether it is better to replace it rather than repair it. What individuals really need is retirement income.

“Few employers want to go back to anything like a traditional final salary scheme. And so we are proposing other ways of providing higher retirement incomes and which avoid leaving employees with decisions that most are ill-equipped to make, such as figuring out for themselves how to stretch out their pension savings throughout their retirement.”

New models for pension saving

Whole-of-life CDC schemes share risks between members and provide pension income rather than pots at retirement, at a fixed cost to the employer. Income levels will depend on fund performance, but WTW – which is the scheme actuary for the Royal Mail CDC scheme – believes that a pension delivered in this way could be on average 55% higher thn a traditional DC annuity for the same cost.

The consultancy said more employers would likely consider this model when regulations allow them to outsource CDC provision to a multi-employer arrangement or master trust.

When it comes to DB with variable increases, the paper stated that, as legislation already allows CDC pensions to be reduced in particularly adverse scenarios, there is no reason in principle to prohibit employers from offering a DB-based variable pension.

The DB guarantee would mean that pensions would not fall in nominal terms, but annual increases would be subject to performance and funding levels. WTW said this approach would provide an expected retirement income 35% higher than a traditional DC annuity.

For employers with existing DC plans, WTW said the “least disruptive option” would be for schemes to provide a CDC retirement income option. This would require additional legislation, but median retirement outcomes could be around 40% higher than a DC annuity.

The variable cash balance with CDC in decumulation approach would involve contributions to a cash balance ‘pot’ with targeted annual increases. Actual increases would depend on investment performance, but the pot value would not go down, providing greater certainty and less volatile outcomes for individuals than traditional DC.

The resulting pot would be used to buy a CDC-based retirement income. WTW estimated this would also produce a median retirement income around 40% higher than a DC annuity.