I’ve had a couple of calls recently for a simple explanation of what CDC is and why it could be useful in Britain today.
CDC is an abbreviation for Collective Defined Contribution. A CDC scheme is created by contributions decided by the member or by a sponsoring employer. Personal contributions could be in the form of regular payments of one off payments (such as the transfer of money from another pension scheme). In this they are common with Individual Defined Contribution Pension schemes (IDCs).
Where CDCs differ, is that they pool these contributions in one collective pot meaning that those using CDC for saving have no choice as to where their money is invested – investment is “take it or leave it”. This collective approach to investments persists whatever the age of the member, unlike IDC, there is no individual investment strategy so no “life-styling”.
While members can choose to leave a CDC at any time , the default position is that the CDC scheme will pay a “wage for life” or “pension” from that same fund. A CDC scheme can therefore be receiving money from an 18 year old and paying money out to a 100 year old using the same fund.
This collective approach means that the investment strategy can be radically different from an IDC. It can take longer to achieve its aims and is therefore well suited to an investment in patient capital”.
This approach to the management of assets has much in common with the way open defined benefit (DB) schemes are invested. However, CDC schemes are under less constraints than DB schemes which have obligations to meet, these obligations or “liabilities” don’t exist in CDC. Instead of liabilities, CDC schemes have “targets” set in terms of outcomes. So a CDC might target providing a percentage of salary for each year in an employer sponsored scheme or might target a percentage of a contribution for each voluntary contribution made by a member.
So the Royal Mail are proposing a benefit structure that is familiar to postal workers using a DB scheme from their DC plan.
But someone who has (say) £100,000 which they want to pay into a CDC scheme as a one off transfer, would get a targeted pension depending on the length of time between the point of transfer and the point when the pension came into payment.
Those wishing to take their pension earlier or later than normal would have adjustments to the pension payable according to rules laid down by the scheme and this would be the same for personal contributions or where an employer is sponsoring.
This distinction between voluntary contributions and contributions made as part of an employer sponsored scheme are helpful in understanding the collective approach to the payment of pensions. There need to be two aspects to the payment of benefits that work
The pensions need to be fair, and they need to be seen to be fair.
This leads us to the hardest part of CDC to understand. Because a CDC scheme cannot go back to an employer – or a private individual – for more money, when investment returns are lower than those needed to pay the target pensions, the scheme manager needs another mechanism to ensure that fair shares are paid.
This will involve reducing the pension (either by not paying anticipated increases or – when times are really tough) actually giving pensioners less one year than the year before. Depending on the level of ambition in the original target, this could happen quite a lot, or hardly at all but anyone who chooses to have their “wage for life” paid from a CDC scheme will have to be aware of the chance that pensions will go down as well as up.
I have tried in this brief description, not to oversell the benefits of CDC. There are indeed many benefits to Individual DC which CDC does not enjoy;- these include
- Individual choice over where money is invested
- Guarantees on income (where an annuity is used)
- Flexibility on how money is paid to the member (where drawdown is used)
- Tax planning opportunities (where the retirement pot is thought of as inheritable)
- Advisory fees (where members want advisors to be paid from their individual pot)
Set against these disadvantages certain advantages that come from a collective approach
- The right to move from collective to individual DC at any time (including when a pension is in payment)
- A much higher level of certainty about retirement income than an IDC
- The advantages that come from long term investment horizons (patient capital)
- The advantages that come from economies of scale
- The protection from pooling life expectancy – the pension lasts as long as you do.
So we can see that CDC suits a certain type of person. That kind of person is somebody who doesn’t want to take. or pay advisers to take, personal decisions on their retirement income. Somebody who wants more certainty than they get from drawdown and more pension than they get from an annuity. Someone who is happy to give control of the investment of their money to a trusted third party.
As you can see from this explanation, there will be a large number of people who will not want to be a part of CDC and it is important they can feel they can do their own thing or join a CDC and opt out of it on “fair value terms” at any time.
But by the same standard, there are many people who will see this collective approach as just what they want. 90.1% of the CWU members who voted on their future pension rights, voted for a CDC approach over an IDC approach. While this may have been a peculiar decision to the Royal Mail, it accords with most other collective decision making (auto-enrolment opt-outs for instance).