Collective Defined Contribution - the future of pensions in the workplace?

This time, we thought we’d look at something new. It’s a new option (and it is just an option) for workplace pensions. It’s something that’s potentially positive for both employers and employees. We’re looking at a way of offering a potentially more generous (and therefore more attractive) pension offering for your staff without the risks and costs of a traditional final salary-type offering.

Many employers already recognise that the minimum levels to comply with automatic enrolment duties (3% employer, 5% employee including 1% tax relief) won’t deliver much in the way of a comfortable retirement for most people. It’s an awful lot better than nothing, of course. When combined with the state pension, which has increased significantly over recent years due to the ‘triple lock’, this provides at least a base for retirement saving.

Is there another way?  Is there, for want of a better phrase, a third way..?

There might be. It’s entirely optional, but there’s a new route to provide a better, and possibly simpler, route to pension saving for staff.

Collective Defined Contribution (CDC) arrangements are pretty new for the UK, but have a long history in the Netherlands. They were first discussed seriously in the UK as part of a settlement agreement between Royal Mail and its unions. In exchange for the eventual closure of the current (defined benefit) Royal Mail pension scheme, the parties agreed that as soon as the law allowed, a CDC scheme would be set up. Royal Mail now has a CDC scheme in operation, the first in the UK. Others are coming.

So what is CDC?

It is a way to take the ‘low risk for employers’ characteristics of money purchase or defined contribution (DC) pension schemes, but to put them in a wrapper which makes it easier and clearer for employees to save for a certain level of retirement benefit.

However, they are also likely to be established under trust, and designed to deliver certain levels of benefit, which makes them look and feel more like defined benefit (DB) (final salary type) pension schemes.

They have characteristics of both, but CDC is really a new kind of pension scheme.

The ‘collective’ element is based on the fact that an employer, or groups of employers, set up or join an arrangement under which all of the pension savings of their employees are grouped together for economies of scale. The joint purchasing power of the members’ funds is used to get better deals and to open up a wider range of investments to the group. Where many employers join together under one master trust ‘umbrella’, that purchasing power is extended.

Because of the economies of scale, standalone schemes are going to be the preserve of the largest employers, like Royal Mail. But other employers should soon also be able to take advantage of multi-employer schemes.

That may sound as if it’s similar to a DC group personal pension arrangement (GPP). And there are some similarities. But how the investments are targeted towards a specific level of benefit outcome is different. And members don’t need to make complicated decision about investing their funds, or indeed how they draw their benefits. In fact, a certain level of benefit is targeted, which leads to an agreed level of contribution. And when the time comes to draw those benefits, the options sound really familiar – an optional lump sum and then a regular income (usually increasing with inflation).

In the early stages of its development in the UK, CDC was called ‘defined ambition’. Although it’s probably sensible not to use the word ‘defined’ about any new pension structure, and CDC is a better description of the nature of the arrangement, ‘defined ambition’ does give a flavour of what’s intended. There are certain levels of targeted benefits in retirement, so to that extent they are ‘defined’. But there is no certainty or guarantee of those benefit levels, and no requirement for an employer to fund a certain level of ‘pension promise’.

So the benefits set out, if not ‘defined’, are indeed just an ‘ambition’. And even if they are achieved, that does not mean they will always be paid at this level, or that they will be increased. That of course makes the structure much more like a defined contribution or money purchase arrangement. Benefits are paid based on what the assets of the fund can afford from time to time. Employers don’t have to stand behind a given level of pension promise, no matter what.

But that ambition is the key difference between CDC and conventional DC. There is a genuine target, although not a binding one. And contributions and investments are set in order to give members a good chance of meeting it.

With CDC, employees can be offered, or select, a target retirement income for a given age, and the employer and employee contributions to reach it. When they come to retire, the main options will be a lump sum and a pension for life. Simple (relatively). And the Netherlands’ experience suggests it will tend to provide much better pension outcomes for individuals who save into a pension during their employment.

What are the advantages for employers?

The key advantage is that CDC offers what looks a lot like a ‘traditional’ DB pension, without the risk of it becoming a long-term financial millstone for you as an employer.

This means CDC benefits, unlike those of DBs schemes can go down as well as up. That can happen while pensions are in payment. The risk remains with the individual, not the employer, although CDC is structured to reduce those risks as far as possible.

Benefit increases can and will also change from year to year, depending on what is affordable. Crucially, and this is baked into the structures of CDC, all benefit targets are just that – targets, not required levels of benefit.  Employers cannot be asked to make good any deficit, because there is no such thing as a deficit in CDC.

If employers use a third party master trust provider, the administration, once the scheme is set up, shouldn’t be much more complex than for conventional DC. Employers will need to work with staff to agree targets and contribution rates, and there may be more monitoring of contribution levels over time, perhaps even to reduce them if targets are in reach, and employers can’t be required to increase employer contribution levels unless something to that effect is agreed with staff. So it’s not as complex or as time-consuming as old DB used to be. And unless an employer wants to set up its own CDC trust, they won’t need to find and appoint trustees, nor discover that running a pension scheme takes up far too much of senior management’s time.

Employers can also use CDC as part of a flexible benefits arrangement, allowing employees (subject of course to automatic enrolment minimums) to choose and to change their contribution levels (and possibly the employer contribution if contribution matching is offered) as their needs change through their working life.

This is too good to be true. What’s the catch for employers?

In CDC, schemes will usually be targeting a higher benefit level, so employer and employee contributions are probably going to be higher than for regular DC schemes, and indeed the minimum auto enrolment levels. Even a standard DC scheme will cost far more than auto-enrolment minimums if employees are to have a chance of a decent income in retirement, but CDC, with its targeted benefits, makes this more formal.

Employers can, of course, set whatever employer contribution levels they want, with the employee choosing to make whatever contributions they can or want to make in order to target a specific benefit. Both employer and employee contributions are tax-free, and salary sacrifice can be used (assuming it survives the next and future Budgets) to reduce the cost further.

But for most employers, the targeted level of benefits is likely to mean there are higher contribution costs. After all, if too much is put on the individual, it is likely to become unaffordable and unattractive to them.

It may also be harder to make changes to schemes, and contribution levels, as to do so will mean a move away from the targeted benefits. So it is not as flexible as a DC scheme can be.

And if you wanted to be cynical, you could say that this sounds a lot like traditional final salary pension schemes used to be. Although there was a set promised amount, back in the day if the pension scheme didn’t have the funds and the employer couldn’t make up the difference, in practice members got what the scheme could fund. What’s the difference now? What’s to say that following an underfunding scandal a future government won’t convert CDC into something that looks like current DB provision, with related employer obligations? But that’s not how the legislation is written.

And it’s not how it’s worked in practice in the Netherlands. During the pandemic, CDC funds there reduced benefits in payment to reflect the reduced strength of the scheme, and cancelled planned payment increases. Employers weren’t asked to pay any more. And because CDC is by its name and nature a defined contribution arrangement, they never should be.

Something to think about...

CDC won’t be for everyone. It will cost more than most conventional DC arrangements. It is more complex to administer, although probably not prohibitively so.

But for some employers, especially where pension offerings and wider employee benefits can be a recruitment and retention advantage, they might be something worth looking into. And just as for Royal Mail, where you are looking to de-risk your pension exposure, and move away from DB pension schemes, offering CDC in its place might just help soften the blow. 

CDC probably isn’t the future of pensions. But it may be a future.