DB pensions – and the guaranteed retirement income they bring – are well and truly a thing of the past, with a mere 5,000 or so left in the UK,most of which are closed to new members.
But with the onus of retirement saving now solely on the individual, DC pensions leave many at risk of lacking the financial means to support the retirement they envisage. The average UK worker faces anestimated £115,000 retirement income deficit.
Enter collective defined contribution (CDC) schemes. CDC schemes are essentially an amalgamation of traditional DB and DC schemes. They provide an income for life – reducing the likelihood of pensioners running out of money, a very real risk with DC – but with no guaranteed value – therefore removing the burden from employers to fund deficits and unpredictable costs.
Too good to be true?
Simply put, member and employer contributions are pooled in a collective fund such that members’ exposure to investment and longevity risks are shared. In a typical DC scheme, members would expect to de-risk from age 55. But, due to the pooling of risk inherent in CDC schemes, members can retain exposure to higher-returning assets for longer, avoiding the need to stunt pension pot growth prematurely. This allows members the potential to earn more than they would under a DC arrangement.
One of the most idiosyncratic risks that individuals face when considering saving for retirement is longevity; a key benefit of CDC schemes is that this risk is pooled. This means that when a member unfortunately passes away earlier than the average life expectancy, their remaining assets can be used to support the members who surpass this average. While this addresses one of the largest risks that individuals face in DC schemes, it also raises questions around intergenerational fairness, with those living less effectively subsidising those who live for longer.
This, alongside concerns surrounding the smoothing of investment risk, were addressed in the DWP’s recent consultation on extending opportunities for CDC schemes, which closed on 27 March 2023. In this, the DWP also consulted on the expansion of CDC arrangements to cover multi-employer and decumulation-only schemes.
What changes do CDC schemes require from an investment perspective?
Primarily, CDC schemes open the door to longer-term investments that have always been difficult for DC schemes to access and are perhaps less attractive for DB schemes as they consider insurance transactions (i.e. buy-ins and buyouts). In fact, following the LDI crisis last year, many DB schemes have been forced to exit their illiquid positions early due to liquidity constraints.
Another consideration of a longer investment time horizon is the increased prevalence of risks such as climate and demographic changes. CDC investments must be aligned with managing these risks.
Consequently, CDC schemes have the potential to consider investing in interesting and emerging opportunities within areas such as private markets, which wouldn’t otherwise be an option for many pension savers. Some suitable assets might include renewable infrastructure and nature-based solutions, both of which allow members the potential to generate meaningful returns while contributing to real-world decarbonisation.
What impact would this have on member engagement?
The heightened focus on member engagement in recent years, sparked by an increased awareness of how pensions can be invested in a sustainable and impactful way, has been monumental in encouraging DC pension savers to think about retirement.
For the most part, longer-term investments are inherently more tangible and, therefore, easier to conceptualise. For example, your pension savings helped build this bridge or contributed to reducing carbon emissions. This can make it easier for members to engage with what happens to the monthly contribution that leaves their paycheque. And although this may not always result in increased contributions (one of the most obvious ways to address the retirement income deficit), it should hopefully lead to members thinking more deeply about how they save for their future retirement. Perhaps this can be one small step in making pensions a more approachable topic in the UK, much like how 401(k) is a more common topic of discussion across the pond.
What next?
Since its introduction through the Pensions Act 2021, CDC has so far failed to move into the mainstream. However, the latest consultation is an example of a positive step in addressing the end of DB pension arrangements and the challenges posed by DC for individual members.
Carolyn Schuster-Woldan is managing director of Redington's investment consulting team
