Why CDC is not the miracle cure for retirement saving

The Department for Work and Pensions highlighted four potential benefits offered by the scheme structure over conventional DC. Looking at each of these further, CDC is not the miracle cure for the UK’s pension ills it is sometimes presented as being.

The DWP’s first suggested benefit is collectivisation. If assets were invested collectively without the need for daily liquidity, this could enable longer-term investments to be used, potentially boosting investment effectiveness.

For CDC to work in the UK, it requires several years of legislative build

Scale, DWP’s second potential benefit, is a good thing for any form of pensions. Scale permits lower charges, which mean higher investment returns, and in turn higher pensions.

However, scale is a necessity for, rather than a consequence of, CDC. The first UK scheme may need to establish its own administrative framework, set up a unique operational framework with certain fixed running costs, appoint advisers to agree its investment strategy and carry out regular actuarial valuations.

It may therefore require a provider or employer that is prepared to make a significant initial commitment to a scheme. 

That brings us to the third potential benefit: not annuitising. It has been claimed that paying pensions from a CDC scheme could provide pensions 10-25 per cent bigger than the annuity market.

The idea is members remain invested in return-seeking assets, which should provide better longer-term returns, and draw an income from them.

Using the scheme’s assets to pay pensions would cut out the insurer’s profit margin. Meanwhile, the intergenerational nature of CDC plans could leave pensioners less exposed to a fall in the value of return-seeking assets than individuals in drawdown.

Unlike annuitants, CDC pensioners’ incomes could still be cut; but, unlike for individuals in drawdown, some of the pain could be shared with younger members. 

This leads us to the DWP’s fourth benefit: intergenerational risk-sharing, which is also perhaps CDC’s Achilles heel. The needs of pensioners must be balanced against the needs of younger members.

The reverse is very much true as well. A steady supply of individuals of all age groups is essential for CDC.

Keeping members' trust

Members will need to be convinced that their generation is treated fairly. As the DWP has noted, CDC requires a considerable boost in the trust required from members of scheme management. How will this trust be engendered?

In CDC, funding rates are fixed, so if investment and longevity assumptions are not borne out, pensions in payment may need to be reduced. Selecting the assumptions to determine whether benefits should be cut is not easy. 

Gaining trust requires members to know and understand they may not get what they expect of their pension and to accept the circumstances when they do not get what they expect. 

Where this happens in DB or DC, members can at least understand why it has happened; by comparison, CDC benefit adjustments could look like the outcome of a black box.

There is also political pressure. Setting assumptions could become a political football that undermines the solidarity of the overall system. Very crudely, older pensioners and employees may want future return assumptions to be high, to permit existing capital to be spent now.

Conversely, younger members may want future return assumptions to be low, to ensure existing pensions are only paid if existing capital warrants it.

The fundamental fact that CDC is defined contribution from an employer perspective is clearly attractive. From an employee perspective, the targeted pension should look clearer than DC’s vague projections, and the hope is that actual outcomes could be less of a lottery than in conventional DC. 

When something sounds too good to be true, it usually is. For CDC to work in the UK, it requires several years of legislative build and either a material upfront investment or scale. Further, it needs a guaranteed flow of new entrants, possibly industry-wide but perhaps more likely on a cross-industry basis.

Will CDC take off? Perhaps. Will it dislodge DC as the most used pension regime? Perhaps not.

Will Aitken is a senior DC consultant at Towers Watson