Those of us who were involved in the with-profits world know that collective arrangements can deliver excellent outcomes over long periods.

We also know that they can become difficult to understand, difficult to govern and, if not designed carefully, vulnerable to intergenerational tensions and loss of trust.

Over time, however, the development of the regulatory framework, particularly for unconnected multi-employer schemes (UMES), has addressed many of those concerns. As a result, I have become increasingly optimistic about the role CDC could play in the future UK pensions landscape, provided governance evolves alongside it.

My initial concerns

When CDC was first proposed, I could not help seeing parallels with with-profits business.

Members often struggled to understand how bonuses were determined, what smoothing really meant and how their interests compared with those of different generations of policyholders.

My principal concerns around CDC fell into four broad areas.

Intergenerational Fairness: The most obvious concern was whether one generation could be advantaged at the expense of another.

In any collective arrangement, there is a risk that optimistic assumptions or inappropriate benefit targets result in one cohort receiving more than its fair share of the available assets, leaving future cohorts to bear the cost. The experience of with-profits demonstrated how difficult it can be to identify such transfers until years later. Especially if smoothing has led to asset buffers or deficits.

Over-reliance on smoothing: Smoothing can be valuable. It can also create problems if it obscures reality. My main initial concern with one of the versions of CDC that was being discussed was the ability to have asset buffers – i.e. hold back good investment performance for those years when performance is not so good. This led to the so-called ‘estates’ that many with-profit funds had built up over the years and arguments over who owned these estates (in many cases they belonged to policyholders from hundreds of years ago).

One of the great strengths of CDC is that the pensions provided will move up and down to reflect actual experience. My concern was that pressure would emerge to minimise reductions and maintain benefit levels even when economic circumstances justified downward adjustments.

Once expectations become disconnected from reality, confidence can be damaged when corrections eventually become necessary.

Complexity and communication: Collective systems inevitably involve judgement.

Members generally understand individual DC accounts because they can see a pot with their name on it. They understand traditional DB pensions because benefits are explicitly promised by a sponsoring employer.

CDC sits somewhere between the two. The challenge is explaining clearly why benefits can change and why that variability is not a flaw but an integral part of the design.

If members do not understand the mechanics, they can easily perceive normal adjustments as failures.

Governance risk: Finally, I was worried about governance. CDC trustee boards would be making decisions that directly affect pension outcomes across multiple generations of members. The role seemed likely to require a combination of investment expertise, actuarial understanding, behavioural insight and strong communication skills.

That is a demanding governance model. Having been a with-profits actuary in the past and performed smoothing calculations and recommendations, I am acutely aware of the judgements that the trustees of CDC schemes will need to apply.

Why the UMES framework changed my view

The development of the regulatory framework for UMES addressed many of these concerns.

Smoothing: Thankfully, the rules laid down for UMES and Retirement CDC (R-CDC) do not allow smoothing of investment returns and insist on assets matching liabilities at the end of each year. This addressed one of the main risks that I thought the industry was downplaying.

Smoothing is actually performed on the pension benefits in an innovative way. Pensions are purchased by contributions, with a target level of increase. The intention is then for this target level of increase to absorb any variations in investment markets. So only extreme continued falls in asset values would lead to a reduction in the pension itself. This is further protected by the application process for UMES. As part of the application, the Trustees need to perform a viability test on the design of the CDC. The appointed scheme actuary will need to do the stress testing and is required by the recently issued FRC guidance to note any scenarios where the CDC will not be able to provide pensions that increase in line with prices.

Explicit focus on fairness: The framework places significant emphasis on actuarial modelling, monitoring and demonstrating fairness between cohorts.

Rather than assuming fairness will emerge naturally, schemes must actively assess it. This is a significant step forward compared with many historical collective structures and is a challenge that neither DC nor DB scheme Trustees have had to face.

Actuarial assumptions in DB and DC schemes don’t affect the actual benefits paid to members (not in the first order – there are potential second order effects if a DB scheme becomes insolvent or employer cuts benefits). However, in CDC schemes they do affect individual members’ actual paid benefits. The benefits provided will be a combination of the value of the invested assets and the way that the actuarial assumptions allocated those assets to the members of the CDC.

Transparent adjustment mechanisms: Perhaps most importantly, CDC benefits are designed to adjust when necessary.

This may initially appear unattractive compared with guarantees, but it is actually one of the strongest protections within the model. By allowing changes to pensions (and hopefully just pension increases) rather than requiring additional external support, schemes reduce the risk of hidden imbalances building up over time.  The UMES regulations require the proprietor of the CDC to hold capital to support the scheme – in excess of the value of benefits.

Strong authorisation requirements: The authorisation regime establishes high expectations around governance, systems, risk management and communications. Collective arrangements should be difficult to establish. Given the complexity involved, that is entirely appropriate.

Clear separation from defined benefit: The framework also makes it clear that CDC is not simply DB without a sponsor guarantee. That distinction matters greatly. Success depends on members understanding that outcomes are targeted rather than promised.

The potential benefits of CDC

Having moved beyond my initial reservations, I believe CDC offers some genuinely valuable opportunities.

Better retirement income from existing contributions: There are many figures being quoted about the extra pension that will be achieved by a CDC member over a pure DC member. The figure quoted most is the pension provided will by 60% higher in CDC than DC. This is an extreme and compares a person in their 20s investing in CDC for their whole life and receiving a pension until they die with a person of the same age in DC who prior to retirement invests in bonds and then purchases an annuity at retirement age. This 60% is then a combination of the extra investment return generated and the fact that CDC in retirement provides a greater pension than an annuity (after stripping out the life insurance capital requirements, profit and lower expected return from lower risk assets).

The extra investment return is expected as the investment time horizon that can be run by looking through retirement and investing collectively will be on average 15 to 20 years longer. This allows a greater allocation to risk assets (e.g. equities) which should generate greater returns in most cases over that time period.

Improved pension adequacy: More importantly, CDC may help address pension adequacy from two distinct angles.

1. Getting more value from current contributions. The first route is improving outcomes without increasing contribution levels. By pooling risks and seeking long-term investment returns, CDC has the potential to generate a higher and more stable retirement income from the same contribution base. In a world where contribution rates often remain inadequate, extracting greater value from existing savings is valuable.

2. Encouraging greater participation and saving. The second route is behavioural. One reason many people fail to save enough is that the pension system can appear overly complex and uncertain. If CDC can provide a pension-like income that members find easier to understand and more relevant to retirement planning than an individual pot, it may increase confidence in pension saving. It may also help with the inadequacy debate. As pensions will be quoted as contributions are made, it will be much easier for members to see what level of pension they are targeting. This will more easily highlight potential shortfalls and hopefully, combined with more confidence, lead to higher contributions.

This will help future generations much more than current generations. Some of the bigger problems for those nearing retirement may be helped by R-CDC as they won’t benefit from the returns achieved in CDC during the working life stage.

Remaining concerns

Despite my growing optimism, some important questions remain.

Communication during downward adjustments: The real test of CDC will not come when pensions increase. It will come when increases are cut back and/or pensions need to be cut. Trustees, advisers and policymakers must resist any temptation to portray CDC as a one-way bet. Long-term credibility requires honesty about both upside and downside.

Measuring fairness: Fairness is not an objective fact. It is ultimately a judgement. Even sophisticated modelling cannot eliminate debate about whether outcomes are equitable between generations. Governance frameworks must therefore be capable of managing disagreement and maintaining confidence. Different CDC schemes may target different populations and therefore have different designs.

Political risk: Any system that adjusts pensions can become politically sensitive. There will inevitably be pressure to intervene if pension reductions occur. Maintaining confidence in the fundamental principles of collective risk sharing will be essential.

There are already some signs of this. The FRC technical actuarial guidance already requires Trustees to test the ability to pay increases in line with prices. If all UMES seek to pay pensions that increase, different levels of increase could be the main difference between the pensions quoted. If the minimum expectation is increases in line with prices then there is less scope for differences in scheme design.

And dare I say it – guarantees!

Competition, scale and value for money: Initially it was looking like CDC schemes could distinguish themselves on the pensions promised. However, as there is now an expectation around pensions increasing in line with prices, it is difficult to see many schemes offering significantly different benefits to this. There will be other issues that will make schemes less comparable i.e. guarantee periods after retirement, partner benefits, transfer rights etc. However, these will probably be standardised over time and, if not, the value will be easily compared.

So how will schemes be compared. If populations are sufficiently different then there could be differences in how pensions are allocated over generations. However, I can’t see this being a major differentiator for schemes and so with a certain level of contributions, and an expectation to pay increases in line with prices, investment performance will be a clear differentiator.

Investment performance, and in particular a continued decline in equity markets over a sustained period, led to significant issues in with-profits in the 1980s, despite their ability to smooth performance over multiple time periods. CDC do not have this flexibility. Individual CDC schemes will have issues if they don’t achieve performance in line with competitors. CDC itself may have issues if we have a sustained downturn in markets. This may then lead to derisking and reduce the excess return expected. However, I suspect that even in these scenarios CDC will still provide better benefits than pure DC.

Schemes may take different levels of investment risk, thus implying different levels of volatility in the increase provided – if schemes go down this route then member communication will be key. For CDC to be successful I think the outcome needs to be pensions that are easy to understand so I cannot see the development of low risk, medium risk and high risk CDC schemes.

As investment performance will be the main driver of benefit adjustments, will ‘value for money’ come into scope in a number of years. I am not a fan of the way value for money is proposed for Mastertrusts and I expect there to be issues when it is in force. Hopefully the lessons that will be learnt from that process will avoid a similar requirement for CDC.

The trustee challenge

This brings us to perhaps the most critical issue: trusteeship.

CDC trustees occupy a fundamentally different position from either traditional DB trustees or MasterTrust trustees.

CDC trustees are different from DB trustees as DB trustees focus primarily on covenant, funding and employer support. When problems arise, attention often turns to the sponsor’s ability to make good any shortfall. CDC trustees do not have that safety net – there is not expected to be any shortfall – and their primary responsibility is maintaining fairness and sustainability within the collective arrangement itself.

CDC trustees are different from master trust trustees as the latter oversee individual DC outcomes, where benefits are largely determined by member account balances. CDC trustees are responsible for a collective system where decisions can directly influence outcomes across different groups of members. The intergenerational dimension is substantially more significant.

Successful CDC trustee boards will need a deep understanding of actuarial concepts, strong investment expertise, an appreciation of behavioural economics, excellent communication skills, the confidence to make difficult decisions, and independence from short-term pressures.

Above all, trustees must understand the purpose of the arrangement. Their role is not to maximise outcomes for any particular generation but to preserve confidence, fairness and sustainability across all generations.

Conclusion

My experience in the with-profits world initially made me cautious about CDC. History teaches us that collective financial systems can fail when governance, transparency and fairness are compromised, especially if smoothing of asset returns is allowed.

However, the development of the CDC framework, particularly for UMES arrangements, has addressed many of the concerns that originally worried me. The emphasis on fairness, transparency, robust governance and benefit adjustment mechanisms provides a much stronger foundation than many historical collective models enjoyed.

CDC is not a replacement for every form of pension provision. Nor is it a magic solution to the UK’s retirement adequacy challenge. But it has the potential to improve retirement outcomes, make better use of existing contributions and reintroduce a focus on retirement income rather than simply asset accumulation.

Its long-term success will depend not only on design and regulation, but on the quality of trusteeship. The best CDC trustees will combine technical competence with the wisdom to understand that their primary responsibility is stewardship of the collective across generations and that investment performance will be key to the benefits provided. As an ex with-profits actuary, that is both the lesson of the past and the challenge for the future.

Bobby Riddaway is an independent trustee and managing director of HS Trustees. He is also founder and chair of the Trustee Sustainability Working Group, a cross-industry group of asset owners aiming to improve sustainability practices in UK pensions.