By Professor Charles Sutcliffe, ICMA Centre
In the recent Queen’s speech, the government announced plans to introduce collective defined contribution (CDC) pension schemes in the UK. These schemes, which are common in the Netherlands, have a mixture of the attributes of defined benefit (DB) and defined contribution (DC) schemes. The Dutch have industry-wide CDC schemes, and so their CDC schemes are multi-employer schemes.
In a CDC scheme the sponsor pays a fixed contribution rate, as in a DC scheme, and faces no risk. The members of a CDC scheme pay a fixed contribution rate, and accrue benefits in the same way as in a DB scheme. (In the Netherlands this is usually on a career average revalued earnings basis.) But the payment of these accrued benefits is conditional on the financial health of the scheme. Collectively, the members and pensioners bear all the risks (e.g. investment risk, longevity risk, interest rate risk, inflation risk, salary risk, and so on).
The contributions to a CDC scheme are invested in a pooled manner by the trustees of the CDC scheme, and if the scheme is in deficit the inflation indexation of benefits is reduced for both members and pensioners. In extreme situations, once indexation has been reduced to zero, benefits may be cut. Conversely, if there is a large surplus, bonus indexation can be paid. As for DB schemes, pensions are paid by the scheme, and not via the purchase of annuities.
CDC schemes have some major advantages over DC schemes. Five studies have found that a CDC scheme produces a pension that is about one third higher than the equivalent DC scheme. In addition, individual CDC scheme members can make more accurate predictions of their pension than is possible with a DC scheme because the risks are shared across the generations, as well as within generations. The much higher CDC pensions are because of (a) cost reductions due to economies of scale and the absence of individual investment pots, (b) riskier asset allocation as pensions are paid by the scheme and not via annuities so there is no need to reduce risk as retirement approaches, and (c) because the absence of annuities removes the costs and mistakes of annuity purchase by pensioners.
Because there is risk sharing across and within generations of members and pensioners, the rules by which the risks of a CDC scheme are shared are very important. The Dutch call this a policy ladder, e.g. how indexation is adjusted in response to a deficit. This risk sharing means that new members of a CDC scheme may be required to help bail out an underfunded scheme, and so may refuse to join unless this is made compulsory. Similarly, if the number of scheme members is shrinking over time, the costs of a deficit will be spread across a progressively smaller and smaller number of members. This may place a disproportionate burden on young members. Recently some young people in the Netherlands have expressed disquiet about CDC schemes.
The precise details of how CDC schemes will operate in the UK have yet to be revealed and may differ from the description above. For example, it is not clear whether members of CDC schemes will be allowed to withdraw their pension pot in cash after the age of 55, as will be the case for members of DC schemes from April 2015.
Overall CDC schemes have some powerful advantages over DC schemes, and their legalization in the UK will offer the choice of another type of pension scheme, alongside DB and DC.