If you’re thinking of running a CDC scheme, make sure you have deep pockets. The application price alone is an eye-watering £77,000. This compares with £23,000 to apply for master trust authorisation. No one will make an application without being  in deadly earnest. The days of the zero-cost HMRC registered scheme are long gone.

The Pension Regulator’s Draft Code of Practice for CDC schemes is exhaustive and intimidating. The application price is a foretaste of things to come.

Besides the application fee for the ‘primary section’ — the requirements laid out entail substantial cost outlays on staff and administration, with TPR expecting all administrative processes, including IT systems, “to be fully developed and ready to go live at the point of application”.

This high bar will please those who see CDC as a dangerous erosion of DB , but the first time I read it , I worried that those of us looking to provide an alternative to pension freedom are looking at a high barrier to entry.

Having had conversations with one or two civil servants who were peripherally involved, I can now see that what’s going on – while it’s not proportionate to a single employer CDC scheme, makes sense if you are trying to create a framework that encompasses multi-employer and “no-employer” schemes (schemes that pay pensions in exchange for people’s pension pots).

I would like to see estimates of the cost of compliance with this code, both initially and on an ongoing basis. They appear to be high – too much stick – not enough carrot?

We can think of this code in terms of sticks = soft sticks are to be applied to ensure members  are properly told what is going on and hard sticks applied to ensure that the regulators know what is going on (and I suspect that both the PRA  and FCA are taking a lot of interest in this ).

The soft stick – “communicating with members “

The eye-catching section of the draft (for the pensions press) is the section on member communications which emphasises not just the need to push out information on the scheme but to prompt, record and act on member feedback to it.

This is a new feature of “best practice” which makes sense.  Many DB schemes have lost touch with their memberships, sometimes with bad consequences – we need look no further than BSPS for an example.

However, the area of the code that will create most debate is the highly prescriptive section on funding requirements.

The hard stick – managing risks through the CALP

The document introduces a new acronym to pensions – the CALP or “costs , assets and liquidity plan”.  This is a separate part of the CDC scheme which is invested as a contingency fund and outside the fund which is going to pay pensions.

Like some others, I read about the CALP thinking that it referred to the main body of the fund. Infact it turns out to be a little slither of the main scheme designed to ensure members don’t have to pay for sorting out problems, from reduced pensions.

The information in the CALP is grouped into four sections:

1. Costs in relation to benefits
2. Income in relation to benefits
3. Assets held to meet costs in relation to benefits
4. Liquidity of those assets

Because the CALP needs to be available to meet costs – potentially at short notice, it needs more liquidity than you’d normally expect from a pension schemes. For this reason, the consultation lays out rules ensuring it is not invested in illiquids.

Apart from a minimum amount for liquidity, we do not prescribe the assets that a scheme must hold in any reserves that it maintains. However, trustees must apply a discount, or “haircut”, to the current or book value of the assets held for reserving purposes⁶⁴. The haircuts described below may influence the choice of assets that the trustees include in their financial reserves.

The haircut modifies the present value of an asset or holding. For example, an asset with a current value of £100 and a haircut of 20% would be valued at £80 for the purposes of the financial reserves. This means that the current value of assets held by, or guaranteed to, the trustees in their financial reserves will be greater than that set out in the CALP.

There are different haircut values for each class of asset, reflecting different levels of risk depending on the length of time before they are expected to be called on. Trustees should consider this when assessing the assets they hold and the liquidity they require. Trustees should choose the haircut that most closely represents each type of asset in its financial reserves.

The haircut is designed to ensure that there is a contingency within the scheme to put things right when something goes wrong. It is not there to protect members from market falls .No haircut is needed if you invest in cash but listed equities can only be valued at 80% of the market price.

Now I have to admit to reading this stuff about haircuts and not investing in high risk illiquid assets as the regulation of the main fund, not the reserve and to an extent that was “my bad”.

But I do think that the consultation is disproportionate in the energy with which it talks about the CALP and low-powered when it comes to the management of the scheme itself.

And  please don’t start talking about “guarantees”!

One of the assets that can be counted is a guarantee from an employer. That the word “guaranteed” is kept in this description, suggests that there is scope for a third party (here the sponsor) to provide a binding promise of future funds. The concept of the employer’s covenant remains, though it is a covenant to pay a fixed amount defined by the scheme rules, rather than by the trustees (and the regulator).

As well as the standard employer covenant there is a further promise of income which may come from a Legally enforceable guarantees issued by a “PRA-regulated participating employer or parent company which are not considered as debt instruments”. Presumably the PRA are interested in the liabilities of a CDC scheme on organisations they regulate, an interesting notion as the general understanding of CDC is that the only liability is the promise of a defined contribution. Is this the first step in offering CDC as an insured product?

Is CDC going to end up regulated by the PRA – I hope not! TPR should ban the “g-word” from all discussions around CDC.

Excessive prescriptive regulation?

It is easy to see why it has taken so long to get this draft code to the consultation state (the consultation period is itself is extremely short – lasting to March 22nd, the consultation response document is in itself prescriptive).

The vast bulk of the regulations concern themselves with the likelihood of “triggering events” – points at which the scheme – without remedial action -would go bust. It’s understandable that the code focusses on risk but it’s regrettable that it says so little about reward. The sweet spot of any pension scheme is in its fully open state.

The most important document for trustees will be their “viability report” which gives them permission to open the doors to members and continue to operate the scheme in the sweet spot without prospect of closure.

There are two actuarial tests to ensure firstly that members will always get a minimum back from the scheme and that they do not over draw from the scheme leaving the cupboard bare. These tests need to be completed at outset and on an ongoing basis for the scheme actuary to sign off a “viability report”

This consultation would be much the better by focussing more on what makes a scheme viable and less on “triggering points”!

My verdict

I  look at this draft code of practice as overly cautious, overly prescriptive and offering little incentive to set a scheme up to all but the most deep-pocketed employers. Multiple employers could share these costs if multi-employer schemes were permitted – but would they?

To me. the demand for employer funded CDC is as a safety valve where guarantees can be swapped for a promise better than DC. This is what Royal Mail have done and it’s what other schemes might do as well – including large multi-employer DB schemes that are staying open. What Royal Mail has done is miraculous, but this code of conduct tells us just how hard it has been.

Too much detail about things like trigger-points and this blessed CALP, not enough about what a CDC (and thankfully we are no longer talking about “collective money purchase”) should be doing .  The CDC code of conduct needs to be focussed on tomorrow’s market dynamics.

Most smaller DB schemes are already on their way to self-sufficiency, buy-out or consolidation with others through master trusts. Switching to CDC doesn’t look  an option for distressed employers staring down the  barrel of pension insolvency, their consolidator is the PPF.

Nor do I see many  employers offering their own DC schemes upgrading to CDC. The costs of CDC are too great.

But I do see opportunities for the larger master trusts (those who measure assets in billions not millions). They are likely to bear the kind of costs envisaged here -if there is an obvious commercial advantage in doing so

There are two such commercial advantages apparent. The first is that CDC allows you to keep assets in the scheme for the rest of a member’s life and the second is that schemes are more likely to consolidate to you, if you are offering a simple wage for life pension solution.

And I see those master trusts that get CDC right, consolidating those who don’t.

This is CDC 1.0 and we can expect adjustments to the code to take into account the needs of smaller employers in multi-employer schemes. We will need yet further prescription when we get to schemes where there is no employer but only members -bringing their money in exchange for pensions.

I hope that a modified version of this code will emerge from the consultation, one that provides less sticks and more carrots.

A target pension not a guaranteed one