Pensions: Collective Defined Contribution (CDC) schemes

Collective defined contribution schemes were introduced by the Pension Schemes Act 2021. They create a third type of scheme in addition to the two main types of pension schemes in the UK. These are:

• Defined benefit schemes pay a promised pension which is based on factors such as salary and length of service. A sponsor, which is usually an employer, guarantees the promised benefits are paid. The pension provides an income for life and may also include a retirement lump sum.
• Defined contribution schemes do not provide a guaranteed pension and instead provide a pot of money which can be used in retirement. The value of the pension pot can increase or decrease depending on factors, including investment returns and contributions made.

In a CDC scheme, both the employer and employee contribute to a collective fund which provides an income in retirement. Unlike in a defined benefit scheme the employer does not need to guarantee the benefits paid by the scheme. CDC schemes provide a target pension, if the scheme is under (or over) funded then the pensions it pays can be decreased (or increased accordingly). No CDC schemes have been authorised yet in the UK, though forms of CDC schemes exist in the Netherlands, Denmark and Canada.

What are the advantages of collective defined contribution schemes?

The main advantages of CDC schemes are seen as:

• Retirement in a single package: Members of CDC scheme can both build up a pension (accumulation) and receive a pension (decumulation) in the same scheme. This is similar to defined benefit schemes, although the income is not guaranteed.
• An income without a risk premium: As CDC schemes do not guarantee an income, there is not an additional cost to savers or employers of securing that guarantee.
• Longevity risk sharing: In defined contribution schemes members manage their own pension pots. Because they cannot accurately predict how long they will live there is a risk that people underspend (dying with unused funds) or overspend (running out of money). CDC schemes can manage risk collectively by paying pensions based on average life expectancy across the scheme.
• Investment strategy: it is argued that CDC schemes can take a longer-term investment strategy than defined contribution schemes, because they have a mix of members in accumulation and decumulation.
• Employers: CDC schemes could be attractive to employers by allowing them to offer employees a pension scheme, with an income in retirement, but without the ongoing risk that the employer will need to continue to fund the scheme if it cannot afford to pay that income.

What are the disadvantages of collective defined contribution schemes?

The main disadvantages of CDC schemes are seen as:

• Falling incomes: Benefits in CDC schemes are not guaranteed which means that the pensions paid to members can fall.
• Communications: CDC schemes are often seen as more difficult to explain than defined benefit schemes (which pay a promised benefit) or defined contribution schemes (in which a saver builds up a pension pot which they can decide what to do with).
• Transfers: People who want to transfer out of a CDC scheme will receive a proportion of the collective fund. In defined benefit schemes members receive an amount based on the expected cost of providing their pension benefits. There is a risk that if members with lower life expectancies are able to transfer out of a CDC scheme with the full value of their share, then the advantages of longevity risk sharing are lost.
• Intergenerational fairness: Intergenerational unfairness may occur if an earlier generation’s funds are used to by a later one to pay higher pensions or if a later generation needs to replenish funds used by an earlier one. Due to differences in the design of CDC schemes, this is seen as less of an issue in the UK.
• Some members will be worse off: A consequence of longevity risk sharing is that some members may be worse off than if they would have been in an individual defined contribution scheme, where those who die younger subsidise the pensions of those who live longer.

Regulation

The Pension Schemes Act 2021 provided the legislative framework for the CDC schemes to be set up, including powers to make regulations. The first CDC regulations came into force on 1 August 2022 and allow CDC schemes to apply for authorisation from the Pensions Regulator.

Royal Mail Pension Plan

Royal Mail Pension Plan has developed the most advanced plans for a CDC scheme, after the Royal Mail and the Communication Workers Union agreed to introduce a CDC scheme in February 2018 following the Royal Mail’s decision to close its defined benefit scheme.

Future policy development

There is a possibility of multi-employer CDC schemes being developed. It has been suggested that existing or new master trusts could be used to establish these. A master trust is an occupational defined contribution pension scheme which is intended to be used by two or more unconnected employers.

There has been discussion of decumulation-only CDC schemes being a further stage of policy development. A decumulation-only CDC scheme would be made up only of members receiving an income and none building up pension savings.