Pension schemes fall broadly into two categories – defined benefit schemes and defined contribution schemes. Defined benefit pension schemes promise an income in retirement based on your tenure at an employer and the wage you earn. Final Salary Schemes – often called referred to as “gold-plated pensions” are a type of defined benefit plan.
With a defined contribution (or DC) schemes your retirement pot is based on contributions from the scheme member, with additions from their employer in most cases, and stock market returns over your membership tenure. Auto-enrolment will result in around 10 million people being enrolled into DC schemes by 2018.
Currently, DC scheme members’ outcomes are based purely on their own ring-fenced portfolio within a larger scheme. If you contribute £100 a month, and your employer contributes £100 a month, your £200 will most likely be invested into a blend of assets which changes as you age; becoming more cautiously biased as you approach retirement.
Collective defined contribution (CDC) schemes are a half-way house between defined contribution schemes and defined benefit schemes with no additional funding requirements on the employer.
CDC schemes are based on collective risk sharing. Members’ contributions are pooled together, and rather than taking into consideration the needs of individuals, instead the fund is run solely to maximise stable returns. Income is then paid out of the pooled fund post retirement, with no need to buy an annuity.
“The employer pays a set amount of money each year in to the arrangement – like a defined contribution scheme, and the members accumulate a fixed amount of pension each year – like a defined benefit scheme,” explained Richard Jones, of Punter Southall Transaction Services.
“If the monies within the plan are insufficient to meet the pensions promised then, rather than the employer putting more money in, then the pensions allocated to each member are altered. This is typically done by funding in advance for annual inflation backed increases but only paying these increases if they are affordable.”
CDC in the UK
Plans to introduce CDC schemes were confirmed in the Queen’s Speech yesterday, as well as confirming that compulsory annuities will be abolished.
“Legislation will be brought forward to give those who have saved discretion over the use of their retirement funds,” her Majesty said.
“My Government’s pension reforms will also allow for innovation in the private pensions market to give greater control to employees, extend the ISA and Premium Bond schemes and abolish the savers’ ten pence tax rate.”
The National Association of Pension Funds (NAPF) welcomed the announcement, saying that CDC schemes offer employers increased flexibility and choice in how they can structure pension schemes to benefit members by providing pooled risk, smoothing, and greater certainty.
“Defined benefit schemes have operated on a pooled risk basis for many years and have shown considerable innovation in managing this effectively and at low cost,” said chief executive Joanne Segars.
“For defined contribution schemes the focus must remain on providing good outcomes for members. CDC may well have a role to play in this, but the fundamentals still apply. Good outcomes for members are built on strong governance, low charges and investment strategies based on members' needs.”
But Tom McPhail, head of pensions research for Hargreaves Lansdown said that he doubted whether CDC schemes will live up to the promises of more pension for the same money.
“They work very like with-profits funds with actuaries using their skill and judgement to share returns across members and across generations of members,” he said.
“This was fine as far as it went until the Chancellor stood up and promised that anyone who wants to can take their money out any time from age 55 onwards. This means an employer selecting a CDC scheme may have to explain to their staff why they’ll be missing out on these new pension freedoms.”
Alan Higham, head of retirement insight at Fidelity Worldwide Investment also pointed out this discrepancy.
““The timing of this proposed reform looks odd given that people are to be given total freedom to take their full pension fund at retirement. For these inter-generational risk transferring CDC schemes to work, they rely on both younger savers staying in and older savers keeping their money invested at retirement,” he said. “Many people will prefer taking a full lump sum over a short period at retirement which makes running these schemes challenging.”
There are also doubts as to whether the new 0.75% annual pension charge cap will be applied to CDC schemes as guaranteed pensions such as defined benefit schemes can only deliver on their promises by charging significant additional premiums to cover the cost of hedging investments.
