Collective defined contribution schemes: Smooth operators?

One factor contributing to improved outcomes in CDC schemes is economies of scale leading to reduced administrative and investment costs. However, this will also be achieved through existing DC schemes, and in particular master trusts. Arguably, IDC schemes will have the edge here as the costs of valuing benefits and calculating increases are avoided.

Diversification is a key tool for managing investment risks cost-effectively. Being able to extend investments to illiquid assets will be advantageous for any pension scheme. Not only would they provide added diversification benefits, but the higher expected returns are also an attractive prospect, as the longer investment horizon needed for illiquid investment is a small price to pay for members not accessing their benefits for many years.

Many benefits of CDC could be replicated in large-scale default solutions run by individual DC schemes, and without the attendant operational complexities about exit strategies

Most IDC schemes already use a certain level of diversification. New funds mean it is now possible to access illiquid asset classes through a platform-friendly pooled fund structure. By including a small allocation to illiquid assets within a blended growth fund it is possible to maintain the fund’s overall liquidity, even where gating restrictions might apply to the illiquid portion. Therefore IDC schemes can benefit from more illiquid allocations.

Smoothing returns are also possible in DC

A key feature of CDC schemes is the smoothing of investment performance, so that returns in “good” years are held back to fund better returns in “bad” years.

It is possible to smooth investment returns within IDC also – essentially what a with-profits arrangement will do. However, with-profits are complex to operate and difficult to understand. It is challenging to see a new generation of IDC schemes that are built on simplicity and transparency adopting any form of investment smoothing.

Smoothing returns provides a more stable investment journey for members, but careful consideration is needed to ensure they do not have similar issues to with-profits funds. One challenge of smoothing is being able to distinguish between a downward blip, and the start of a longer trend.

Avoiding derisking

CDC is able to avoid derisking in the run-up to a member’s retirement, allowing them to enjoy growth-style returns for longer. IDC will never be able to emulate this as individual members will always need to look for increased stability around retirement.

The PPI estimated the cost of a derisking approach is around 15 per cent for a typical 10-year strategy. However, a new generation of larger IDC schemes could adopt techniques from CDC.

Default post-retirement solutions could provide a compromise between managing the risks faced by members and allowing them flexibility. For members not looking to purchase an annuity, default provisions could include greater allocations to growth assets at older ages, mitigating some of the need for pre-retirement derisking.

For those members who do purchase annuities later in life, a post-retirement default structure could allow annuities to be purchased in bulk. This delivers better value through the increased negotiation power of large schemes compared with individual members. So the difference between CDC and IDC may not be as big as first thought.

Large-scale default DC could replicate CDC

CDC schemes have some challenges; the extra complexity associated with operating a CDC scheme will generally require more administration and have higher governance costs. In particular, communicating the complex risk-pooling required can be difficult.

There are many reasons why CDC may prove to be unpalatable or unsustainable in the future, not least as fashions change. If history has taught us anything, it is that nothing lasts forever. Arrangements should be put in place today to run down or wind up sustainably in the future.

Finally, the benefit of CDC being a stable asset pool is not too different to an IDC scheme with a default solution.

Many benefits of CDC could be replicated in large-scale default solutions run by individual DC schemes, and without the attendant operational complexities about exit strategies. However, CDC schemes represent progress.

This is another tool in the box for providing pensions that allow cost-effective risk management for both members and employers. I hope today’s large IDC schemes mirror the developments of CDC plans so they can improve the overall outcome for UK pensioners.

Esther Hawley is an associate and senior investment consultant at Barnett Waddingham