Why fairness matters in CDC pension schemes

CDC schemes provide an income for life, at a level that is widely expected to be significantly higher than available from a DC scheme for a comparable spend.

As a result, CDC is expected to be very attractive to the significant cohorts of people who value an income for life in retirement with no complicated decisions to make on investments or when to take benefits and how much. This was covered in our Future of Pensions report.

However, any new pension arrangement needs to earn the trust of members and their employers. Some commentators have questioned the fairness of CDC schemes. This is an important consideration. We believe well-designed CDC schemes are both fair and maintain the other benefits of CDC.

In this blog, we discuss the issue of fairness in CDC and explain how the next generation of CDC schemes are being designed to ensure fairness.

What fairness means in CDC context?

Fairness means different things to different people.

A DC scheme is fair in the sense that a member has control over where their pension is invested and how to use their pot at retirement. The income a member receives in retirement is determined by the decisions they make, and there is no cross-subsidy between the DC pots of different members.

However, in practice only a small minority of savers make active decisions on how to invest their pot, with around 90% of DC members choosing the default investment option.

The highly individual nature of DC can lead to unfairness in a broader sense. Outcomes depend heavily on investment performance and economic conditions during key periods, such as the run up to retirement (when a pot will be at its largest), and if choosing drawdown, during the early years of retirement. These are largely outside members’ control.

This means that different generations of savers can experience different incomes in retirement, even if they made identical decisions. The risk sharing mechanism in CDC manages this to a greater extent.

By sharing risks between members, CDC schemes aim to provide more equitable outcomes over time.

Partner Helen Draper

LCP partner Helen Draper said: “CDC is new and evolving, and we are seeing innovative approaches being considered, including whether to compensate younger members for greater variability in potential outcomes. By sharing risks between members, CDC aims to deliver more equitable outcomes over time.”

Partner Sean Garratt added: “Risk transfer is inherent in CDC, but it is designed to support desirable outcomes: higher pensions, an income for life and no complex decision-making for members. Careful benefit design is key to avoiding unnecessary risk transfer between generations or demographic groups. We are optimistic that the coming wave of CDC schemes will achieve this and earn the trust of future members and their employers.”