The case for collective defined contribution

Matthew Arends explains why collective defined contribution schemes look set to grow in popularity in the UK

Collective defined contribution (CDC) is a relatively new term in the UK pensions industry but appears prominently in the recent consultation from the Department for Work and Pensions. So what is this benefit design and how might it fit into the UK? These types of plans – sometimes called target benefit plans – are common in the Netherlands and are on the increase in some other countries, notably Canada.

There are many potential ways of establishing a target benefit plan. Our discussions with employers show that, as a result of their experiences with DB plans, many of them have no desire for bearing any additional pensions risk. Consequently, our definition of CDC involves a fixed employer contribution rate (say 10 per cent of basic pay). This way, a CDC plan is a DC plan from the employer’s cost and risk perspective.

What distinguishes CDC from DC, though, is the nature of the benefits to members. Instead of accumulating a pot of their own personal funds, a CDC member accrues a target benefit of, say, 1 per cent of career average earnings for each year of membership.

A CDC plan is, by definition, run on a collective basis, so investment decisions would be made by a board of trustees, neatly side-stepping one of the thorny issues with DC pensions: member engagement in investment decisions. A CDC pension would be payable out of the plan, not via purchasing an annuity. This would enable the trustee board to invest in growth assets for longer, something that should produce higher returns on average. This would deliver higher member benefits, with the collective nature of the plan smoothing out market peaks and troughs.

The crucial aspect of the design is that the members’ benefits are not promised, just targeted. If the plan meets expectations, benefits will be indexed before and after retirement in line with CPI. If the plan outperforms, then bonus indexation would be paid. However, if there is underperformance, the benefit indexation is cut back to restore the funding level. In extreme situations, even the face value of benefits would need to be reduced and this would apply to both pensioners and non-pensioners.

Benefit cuts do not sound that appealing, so would they really happen? Our modelling shows that a CDC plan established in this way would only have had to reduce benefits three times in the last 70 years, with two of those occasions being the Great Depression and during the Second World War, with the average face value cut being 7 per cent. This squares with the recent experience in the Netherlands, which has seen cuts averaging 2 per cent during 2012 (De Nederlandsche Banke assess pension funds’ recovery plan evaluations 25 April 2013). In contrast, over the 2009-2012 period, the cost of buying an annuity has risen by 29 per cent and so DC members retiring in 2012 saw their pension 29 per cent lower (not just 2 per cent) than they were expecting three years before.

Balanced against these infrequent reductions, our past modelling shows bonus benefit increases would have been paid every year during the 1980s and 1990s. Our modelling of future scenarios shows that benefit cuts can happen, but are rare, occurring at about a rate of one year in 20, particularly compared to bonus increases which would be paid about every two years in three. Overall, members’ pensions are around one-third higher than a comparable DC plan and the smoothing means that the benefits are also more predictable.

We consider that clear and transparent communications with members are paramount throughout their plan membership. Members – and indeed the regulator and the wider pensions industry – will want to have transparency over bonus policy and experience. This will help to avoid individual CDC plans consistently over- or under-distributing bonuses, which could be an indicator of future problems. We advocate CDC plans publishing their policies on funding, investment and bonus distribution, alongside providing up to date information on the bonus experience.

So although CDC plans may be new to this country, we strongly believe they have a place in the future of pension provision in the UK, giving employers the fixed cost, low risk plan they require while delivering more predictable and higher pensions for members. For further information about Aon Hewitt’s research into CDC please see aonhewitt.co.uk/collectivedc.

Matthew Arends is a partner at Aon Hewitt

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