Workplace pensions in the UK fall into two camps; defined benefit (DB) pensions that offer a promise of the income you might receive in retirement based on how much you earn and how long you’re employed, and defined contribution (DC) pensions that offer no guarantees; your retirement depends instead on how much you and your employer pay in, and how your pension investments perform.
DB pensions have all but died out in the private sector because they are costly to run and leave employers on the hook for uncertain future costs. They are still offered in the public sector, but any private sector workers will now almost certainly be enrolled into a DC pension when they start at a new company.
But, perhaps unaware of the old saying ‘two’s company, three’s a crowd’, the government is currently mulling the introduction of a new type of pension scheme known as Collective Defined Contribution, or CDC for short.
CDC pensions have been thrust into the spotlight following Royal Mail’s decision to close its DB scheme. The company has worked closely with the Communication Workers Union and proposed offering staff this new type of pension. The fly in the ointment is that UK pension rules don’t allow them to – yet.
The way they work isn’t defined, which is one of the problems. Broadly, they aim to provide an income in retirement which is intended to increase, but if the underlying investments disappoint, these increases could be scaled back, stopped completely or, in extreme circumstances, the income could be reduced. The benefit is a target, not a guarantee.
CDC schemes are used in the Netherlands and work by combining all the assets of a scheme’s members into one pot. This collective pot includes both members saving for retirement as well as those already in receipt of their retirement incomes.
In theory, people don’t have to worry about where they are invested – like DB schemes – but employers are not on the hook for uncertain costs that could spiral out of control – similar to DC schemes. There is also some excitement that initial modelling suggests people could end up with bigger payouts in retirement.
However, a target benefit that is not guaranteed could be confusing for members and potentially damaging for pensions overall if the targets are not met. There are uncomfortable similarities with With Profit pensions of the 80s and 90s, which often left policyholders disappointed. Pensions are currently riding high because of the success of the government’s auto-enrolment programme. The last thing anyone wants is to damage this.
The biggest question mark about CDC schemes is their compatibility with the pension freedoms. Since 2015, people have been able to buy a guaranteed income, keep their money invested while drawing an income, or encash their pension entirely. The appetite for guaranteed income streams has diminished and there is a question mark over how many people will actually want a CDC pension that provides only an income in retirement. Experience tells us people with larger pension pots, or those in ill health are likely to want to transfer out. Exactly how people pulling money from the pension at the point of retirement might impact on the returns available hasn’t been modelled.
On balance I expect the government will grant Royal Mail’s wishes and allow CDC pension schemes to be set up. This won’t prompt a stampede of employers moving their staff into this type of plan though while it remains experimental with so many questions left unanswered. Ultimately, these type of pensions provide a retirement income but without flexibility. Today’s retire-as-you-go generation demand more fluidity from their pension to match their modern working patterns.
Nathan Long is senior pension analyst at Hargreaves Lansdown