– A positive step but a long road ahead
28 November 2018
Earlier this month, the Government launched a consultation on Collective Defined Contribution (CDC) pension schemes. If implemented, CDCs could offer a “third way” for pensions that combine features of defined benefit (“DB”) and defined contribution (“DC”) schemes.
For some companies – particularly those who in the past may have been put off pensions by the costs and risks of DB schemes – it is hoped CDC schemes could be an attractive option to reinvigorate the place of pensions in reward strategies. So how do they fare?
Royal Mail benefit structure
The consultation stems from a scheme currently being planned by the Royal Mail for its c.120,000 employees. Under the proposed structure published by the Royal Mail as part of the Government’s consultation process:
- employees build up a target pension of 1/80th of pensionable pay each year (leading to a “career average” type pension), payable from age 67 - but there are no guarantees;
- the cost of the scheme is around 15% of salaries (of which members will pay 4% and the company 11%). There is also a further 4% cost for other benefits (like life cover) and expenses;
- pension increases target CPI inflation + 1% p.a. (so that might be expected to be around 3% pa overall) but the actual increases granted will depend on the future financial performance of the scheme from time-to-time. For example, if investment returns are poor (and the scheme is less than 100% funded), an adjustment mechanism means that a lower increase would be awarded; and
- in the event of very poor longer-term performance (and where pension increases have already been completely stopped) the target benefits would ultimately be cut to ensure the scheme is in balance.
The principle is attractive in many ways. For members, the scheme will appear to offer many of the benefits of annuities. In addition, the “collective” elements offer scale and a crucial ability to take a balanced approach to investment risk.
However, the challenges are significant. In particular, the potential to reduce pension increases (and ultimately benefits) is a key design feature that helps avoid deficits and keeps contribution levels manageable. Effective member communications are therefore essential to ensure lessons are learned from other countries such as the Netherlands where benefit cuts to CDC schemes during the financial crisis came as an unpleasant surprise to many scheme members.
This in turn makes the initial benefit design and costings important to get right. For example, in the Royal Mail structure, achieving the right balance between the accrual rate, target pension increases (which insulate against the risk of cutting back benefits) and assumed investment return assumptions makes a strong design essential to providing pensions that are at the same time attractive, affordable and stable.
The consultation also highlights other significant challenges, such as the treatment of expenses and what might happen in cases of company insolvency – all of which will need to be resolved. This means it could in practice be some time before we see the legislation needed for CDCs to emerge. For most companies it will be a watching brief for now.
However, now the Royal Mail structure has been published, one initial observation is that even without the guarantees of the DB world, the expected cost of providing a sensible target income in retirement is significant – with 15% of earnings only enough to “target” rather than guarantee a benefit that appears modest compared to most traditional DB schemes. Most employees in DC schemes receive significantly lower contributions than this (with automatic enrolment contributions rising to a combined 8% from April 2019). In the short term, and while we wait for CDC scheme legislation to emerge, one positive impact of the debate will hopefully be to support continued increases to DC contributions over coming years.