Could a collective DC scheme be right for your workforce?

The 2021 Pension Schemes Act creates a new framework for CDC schemes. These schemes are intended as a halfway house between defined benefit (DB) schemes, which promise employees a guaranteed pension on retirement, and defined contribution (DC) schemes, under which benefits depend on investment performance of the pot members and employers have paid into. CDC schemes do not come with guarantees, but investments and benefits are managed collectively, which should lead to better results overall.

It is not possible to set up a CDC scheme under current legislation, and it will be some time before a CDC scheme can be established under the new framework. Regulations, regulatory guidance and a new regulatory authorisation process will all be required beforehand, and The Pensions Regulator (TPR) will need to assess any potential schemes that apply for approval and decide whether they meet the required standards.

However, pension provision is a long-term undertaking, for which employers have to plan in advance. Some may well want to start weighing up the benefits, and potential drawbacks, of CDC provision.

What is a CDC scheme?

CDC schemes, like DC schemes, provide no guarantees. Instead, they target a DB-style benefit. Employers make fixed contributions to the scheme with no further liability, other than in relation to expenses. Members are informed of their target income on retirement. If scheme assets prove insufficient to pay the target pensions for members, lower pension increases could be targeted, or a lower level of overall target could be set. Even pensions in payment may be reduced if there is a deficit.

All scheme assets are invested collectively – there are no individual pots. When members retire they are paid a pension from scheme assets. Mortality risk is therefore spread among members rather than borne by each individual member, as under a normal DC scheme. Members can choose to transfer out if they would prefer to buy their own annuity or draw down on their own individual pot.

Why might an employer choose a CDC scheme?

CDC schemes have a number of inherent advantages. Like DC schemes, contributions are fixed: there are no unexpected deficits to plug. Investment and longevity risks are shared between members through collective investment. This means that, as with DB schemes, assets can remain invested in higher return assets over members' lifetimes. CDC schemes can take a longer term view and invest more of their assets in illiquid investments – such as infrastructure and patient capital – which tends to be more problematic for standard DC schemes.

On retirement, members receive an income stream without having to work out for themselves whether to buy an annuity, and without having to calculate how much income they can safely draw down from their pot. Many employees prefer the fact that CDC schemes only offer limited options in relation to contributions and benefits. The risk of members making inappropriate choices is reduced.

What are the potential downsides of CDC schemes?

One of the major problems with CDC schemes is that they are quite difficult to explain. Members may fail to understand that their target income is not guaranteed and that a pension in payment may be reduced.

There is also the risk of intergenerational cross-subsidy: younger members risk subsidising the pensions of older members and ultimately receiving lower benefits themselves. This is a risk if the scheme prioritises the non-reduction of pensions in payment or the retention of a capital buffer over the funding of benefits for younger deferred and active members. As is the case with a DB scheme, accrual of benefits for older members costs the scheme more than accrual for younger member, because older members have a shorter time period in which to achieve sufficient investment returns on contributions paid.

In addition, unlike under an individual DC scheme, members have no investment options and may have religious or ethical objections to some investment chosen for them by the trustees of the CDC scheme. Admittedly, this disadvantage also applies to DB schemes.

Which employers may be interested in CDC schemes?

The new legislative framework has been driven by Royal Mail's promise to the Communication Workers Union in February 2018 that it would establish a CDC scheme once the law allowed.

It is generally assumed that only employers similar to Royal Mail will be interested in setting up a CDC scheme - that is, employers that used to be nationalised bodies, with a significant active workforce and a large DB scheme established before privatisation. These employers may wish to control the ballooning deficits of their DB schemes; and they typically have a strongly unionised workforce opposed to a switch to a DC scheme. CDC schemes could be a good fit for this relatively small and select group of employers.

However, CDC schemes could also be appropriate for a very different group of employers - for example, large tech companies. These companies traditionally provide DC schemes for their staff. This fits in with the flexible and modern image of these companies, which generally avoid taking on the sort of uncontrollable liabilities associated with a DB scheme. However, the employees of these companies may well gradually become more unionised, and may start to demand something viewed as better than a standard DC scheme. They may well be attracted by the potentially better overall benefits of a CDC scheme, and by the innovative, communal approach.

Even large companies may be put off by the cost of setting up their own CDC scheme, and may well prefer to join a scheme established by a commercial provider for multiple employers. The default position under the Pensions Schemes Act is that only schemes for single employers or for employers in the same corporate group are permitted. However, the government intends to consult on allowing CDC schemes for unconnected employers in due course. It may be a while before that happens, but once it does, CDC schemes will become a real option not just for privatised companies, but for other large employers looking to distinguish themselves by offering more than a standard DC scheme.

Co-written by Simon Tyler of Pinsent Masons.