Govt and scheme decision-makers told to tread with caution on CDC

The Department for Work and Pensions is currently consulting on CDC, with the consultation due to close on January 16 2019.

In a recently published report, the PPI claims a mature and stable CDC scheme can produce a replacement rate – which is retirement income compared with working-life income – between 27 per cent and 30 per cent.

Effective member communications are essential to ensure lessons are learned from other countries such as the Netherlands

Steve Taylor, LCP

This compares with a replacement rate of between 12 per cent and 21 per cent in an individual DC scheme (with a 10 per cent contribution rate).

The PPI attributed this outcome to economies of scale from reduced investment and administrative costs, longer investment horizons – with no need to derisk as members approach retirement –  and a more diversified investment strategy, with the ability to invest in more illiquid asset classes.

Potential issues with CDC

However, the think tank’s report, called 'What is CDC and how might it work in the UK?', published on Thursday, highlights a number of major issues with CDC. These include intergenerational fairness and coherence with the existing pensions landscape, particularly with regard to pension freedoms.

There could also be governance problems, in terms of maintaining a certain level of continuity and long-term perspective, with targets being set and revisited on a regular basis.

Moreover, the report highlighted that communication could be an issue, with a need to clearly communicate to members the targeted rather than guaranteed nature of the benefits.

In the report, Louise Farrand, executive director at the Defined Contribution Investment Forum, and Vivek Roy the DCIF's vice-chair, advised government and scheme decision-makers to tread with caution, given that intergenerational inequity is already a very real issue in the UK.

The impetus for CDC comes from the Royal Mail, which hopes to provide CDC as a new scheme for its 141,000 employees.

Jon Millidge, chief risk and governance officer at Royal Mail, one of the sponsors of the report alongside the DCIF, said: “One of the key elements in developing our scheme has been to ensure decisions are made in the interests of all scheme members without bias to any particular group. Critical to this is transparency and communication; rightly major themes in this project.”

Learning from others' experiences

There are pitfalls with CDC, as the Dutch experience in the 2008 global financial crisis showed. Dutch pension contribution increases following the crisis raised concerns about schemes’ ability to pay targeted benefits to pensioner members.

David Pitt-Watson, leader of the Tomorrow’s Investor project at the Royal Society of Arts, said: “We hit 2008 and, of course, at that point it did not look like you had the money that you had before. What are you going to do: keep paying out the same pensions to people or do you bring down pensions in payment?”

He added: “The Dutch brought down pensions in payment by an average of 2 per cent.”

Currently, the Royal Mail is the only employer with advanced CDC plans. Under its proposals, its collective pension plan comprises a defined benefit lump sum section, accruing at 3/80th of pensionable pay, plus increases and a CDC section, accruing at 1/80th of pensionable pay plus increases.

The contribution rates are 13.6 per cent for the employer and 6 per cent for the employee, and average increases are expected to target the consumer price index plus 1 per cent (but not guaranteed).

It has said its proposed scheme is different to CDC schemes in other countries in several ways. Royal Mail said that “we have also learned from others’ experiences, with strict, mechanistic rules around awarding increases (or in extreme years, reductions) across all members equally”.

Steve Taylor, partner at consultancy LCP, highlighted that "the actual increases granted will depend on the future financial performance of the scheme from time-to-time”.

Bob Scott, partner at LCP, stressed: “The CWU provided details of modelling which back-tested the design from the 1920s (when the original Royal Mail DB scheme was founded), which indicated that benefits would only have been cut back in one year during that period.”

Nevertheless, “effective member communications are essential to ensure lessons are learned from other countries such as the Netherlands,” said Taylor, “where benefit cuts to CDC schemes during the financial crisis came as an unpleasant surprise to many scheme members.” 

Design and costings are crucial

Getting the benefit design right and the costings are crucial. “Four key points must be borne in mind,” said, Simon Eagle, director at Willis Towers Watson. “CDC schemes have to allocate money fairly between members, so the design has to be fair in working out pension entitlements; it has to aim at high and stable pensions; it needs to be a simple design which can be easily communicated to members and it must be transparent to the industry as well.”

Administrators will need to design a whole set of new processes and accompanying controls. Jon Parker, director of DC and financial well-being consulting at Redington, pointed to new annual benefit statements, new online portals, new report and accounts and audit processes.

Some critics have likened some CDC plans to ‘Ponzi’ schemes. Ralph Frank, head of defined contribution at Cardano, warned: “If the CDC arrangement seeks to smooth declared returns from year to year and allows returns to be declared that are higher than have been earned (as happened historically with with-profits funds) then the Ponzi scheme concern is valid. Other risks, depending on the form of CDC, relate to operational and computational complexity and the associated communication challenges.”