The case for collective defined contribution
Amid concerns that individual defined contribution schemes will fail to deliver adequate retirement incomes, there has been a great deal of debate about the relative merits of collective defined contribution (CDC).
This article examines the pros and cons of a scheme that falls somewhere between the worlds of defined benefit (DB) and individual defined contribution (DC).
How do collective DC schemes work?
Like all pension arrangements, the defining factor is in the apportioning of risk. In DB the risk is the employer’s; in DC the risk lies with the individual. CDC seeks to risk pool and risk share among members across generations. A ‘target’ level of pension at retirement is set but, if the CDC scheme is underfunded, member entitlements are reduced rather than employer contributions raised. As a last resort, pensions in payment are cut if the solvency ratio demands it. CDC’s inter-generational risk sharing approach enables higher allocations to growth assets and potentially offers significant benefits in the decumulation phase in particular when compared to individual defined contribution in the UK as currently practised.
The challenges of risk sharing and intergenerational fairness
Those sceptical of CDC liken the challenges of risk sharing between generations to a form of pass the parcel. Each generation may be happy to take the risk for an older generation if they can pass the risk ‘parcel’ to a younger one. But what happens when there are no new members and the youngest generation is left holding the parcel? The first CDC generation takes no risk for an older generation, but the youngest generation takes risk twice: for itself and the penultimate generation. Overall, the oldest generation gains at the expense of the youngest. CDC governance would clearly need to ensure that actuarial adjustments were calculated in a manner fair to all members across generations.
The investment challenges
When scheme investments perform well, trustees will decide how to share the ‘profit’. When investments fall in value, they will have to decide how to ‘share’ the loss. From an investment point of view, it is vital to acknowledge the importance of managing the volatility of investment returns, smoothing out the peaks and troughs, so as not to create more variation for each cohort. New contributions help in this respect and therefore create a longer-term investing horizon for all. If the system matures too quickly, and does not offer the attractive features that will draw people into it, then some of the other features that make the scheme attractive simply disappear. The order and timing of investing returns, or sequencing risk, is especially important to CDC schemes, which can help mitigate sequence risk because younger members provide liquidity at attractive valuations during their own accumulation phase when an older member is decumulating.
Is there an appetite for another way?
Would the introduction of CDC further complicate an already complex UK pensions system? Is there an appetite for a third style of pension plan in light of the long-standing and ongoing battle to engage the public on pension matters? Does the prospect of better outcomes outweigh the risks involved? The extent to which CDC provides a plausible means for individuals to share the risks inherent in retirement saving in an efficient manner continues to be the subject of debate. Assuming that an effective legal and governance framework can be put in place, and a sufficient number of members are interested, CDC may yet become part of a widening array of pension structures available to today’s and tomorrow’s workforce.
The DC Investment Forum is currently collaborating with the Pensions Policy Institute and Royal Mail on a CDC report. The report will be released in late November; if you are interested in receiving it, you can sign up to our email alerts here.
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