In brief

CDC schemes - The case for change

Pensions & benefits CDC strategy and implementation

CDC schemes are coming and we believe they will be an attractive option for members and employers alike, providing expected pensions up to 50% better for the same £ amount contributed along with cost certainty for employers.

Sponsors and Trustees should consider the part CDC should play in their future provision and we would be happy to help you explore the options available.

Collective Defined Contribution (CDC) schemes

For today’s working population the challenge of saving enough for a comfortable retirement is harder than it has ever been.

Generous Defined Benefit (DB) schemes, which historically provided good quality pensions, have now mostly closed as employers became increasingly wary of the increased costs and risks of DB provision. As a result, less than 5% of current private sector workers now have access to a traditional DB scheme as part of their current package.

Auto-enrolment has been successful in increasing participation in pensions, but typically this has been into Defined Contribution (DC) schemes. In DC schemes the individual bears all investment risks and the burden of managing their money. Typical contribution rates are also far lower than to the corresponding DB arrangements¹. With the costs of buying an annuity still high, this means that despite DC scheme members’ best intentions, many will find that on retirement their pensions savings are inadequate.

As a result, research from the Department for Work and Pensions suggests that around 2 out of every of 5 working age people in the UK are currently under saving for retirement. This means that many face an unenviable choice: significantly increase pension contributions, in the midst of a cost-of-living crisis, or accept a drop in living standards at retirement.

It seems clear there is a need for more efficient ways to generate good quality incomes in retirement – without the uncertainty on costs that has made DB difficult to sustain.

Enter Collective Defined Contribution (CDC) schemes. CDC offers an alternative to traditional DB and DC schemes, whilst combining attractive features of each.

The risk sharing nature of CDC, and the investment freedom this generates, creates the potential for significantly higher pensions at retirement, perhaps by up to 50% compared to DC with traditional annuity purchase;
Employer and member contributions are fixed, giving sponsors certainty on cost and confidence that pensions spend will remain in budget year-on-year;
CDC provides an income in retirement, avoiding the need for the potentially onerous member decision making deep into old age required by drawdown.

How do CDC benefits compare to traditional options?

LCP’s stochastic analysis based on 2,500 simulations shows that the median outcome from a CDC scheme is expected to be around 50% better than for a traditional DC scheme.

These charts show the indicative expected “replacement ratio” (retirement pension as a proportion of final salary) for a typical CDC scheme and a traditional DC arrangement (that uses a life styling strategy assuming purchase of an annuity at retirement). Both assume the same (12%) annual contribution and look at a 43-year-old with a 25-year career (assuming NRA 68) that purchases a single life annuity at retirement.

The graphs use 2,500 stochastic simulations to illustrate the range of potential outcomes for each arrangement (results will also differ depending on the structure of the scheme and investment strategy assumed).

Notes on the charts

The projections shown illustrate a median CDC replacement ratio of 41% for a 43-year-old joiner (retiring at age 68 after a 25-year career). This compares to a 27% median outcome for a DC saver.

A further key finding is that the ability to invest collectively means that the best CDC outcomes will likely be significantly better than for DC savers. Even in tough economic times, CDC outperforms DC in the vast majority of circumstances.

The median level of expected benefit under CDC is also broadly equivalent to what could traditionally be achieved in a typical DB scheme. DB provides a fixed level of benefits to members but a higher cost to the employer. Typical DB contribution rates for this level of benefit might be 20% or more and would be variable with the potential of additional contributions being required over time to pay any future deficits.

How does a CDC scheme work?

CDC schemes combine the structure of a DB scheme with the cost certainty of a DC scheme.

Benefits are funded by a regular and fixed contribution rate, but the investments are managed collectively. This allows members to share risk and achieve better outcomes at retirement than traditional DC and potentially DB arrangements.

Members accrue a target benefit, in the form of a pension (that can be commuted to a lump sum) payable from the scheme. Importantly, this benefit is not guaranteed. Every year, the trustee reviews the funding level. If the scheme is under or over funded, the trustee can adjust benefits, usually through amending the target for future pension increases.

How does CDC benefit members and sponsors?

When will CDC happen?

Legislation for “single” employer or “connected” multi-employer schemes was introduced by the Pension Schemes Act 2021.

The first CDC scheme is expected to be launched for Royal Mail employees later this year.
Regulations to enable multi-employer schemes should emerge early in the new parliament. These measures have broad cross-party support in particular because CDC schemes, through their investment strategies, have strong potential to contribute to economic growth.
Once new regulations are in place, we expect this to allow multi-employer schemes to come to market from 2026.
A “decumulation only” model of CDC may follow in the future (perhaps by the end of this parliament). This would allow individuals who have built up DC pots during their working lives to buy a CDC annuity at retirement.

Footnote

Industry research published by Association of Consulting Actuaries in 2022 found typical combined employer and employee DC contributions of 12%, compared to around 30% for DB Schemes (excluding deficit contributions).