For those in the pensions industry, the overwhelming theme of the UK Budget 2014 was to liberalise ways in which defined contribution (DC) benefits can be accessed by scheme members. The new flexibilities have been available in limited form from 27 March 2014, and are currently proposed to be fully in place by April 2015.
The pensions landscape is due to change considerably over the coming months. If there is no statutory override allowing members to access DC benefits despite scheme rules, employers will need to decide on the extent (if any) to which they wish to adopt the new flexibilities. In addition, many personal pension product providers may develop new-look savings vehicles offering a combination of flexible drawdown and annuity purchase facilities.
The Queen’s Speech on 4 June 2014 announced two new pension bills, one setting out the framework of the Budget changes and the second enabling the establishment of shared risk schemes, one form of which is the collective DC scheme (CDC scheme). The latter bill, the Pension Schemes Bill, was laid before Parliament on 26 June 2014. The new Bill sets out the framework for CDC schemes by defining the concept of collective benefits, the purpose of which is to enable the scheme’s members to pool investment risk. The Government hopes that this approach will enable members to realise eventual benefit levels in excess of those provided by existing DC schemes. Regulations will later flesh out the detail on such issues as funding, governance, valuation and reporting requirements.
The questions below are some of those most frequently raised regarding CDC schemes.
What benefits are payable from CDC schemes?
Based on the level of contributions that are payable to the scheme, a particular level of benefits will be targeted. This targeted level may take the form of a percentage of final salary for each year of employment (in much the same way as a defined benefit (DB) pension scheme) and may be subject to increases in line with inflation.
The targeted level of benefits is not guaranteed. Therefore, if the assets held by the scheme are insufficient, a lower level of benefits may be paid to the member. Whilst this uncertainty is not unfamiliar to members and sponsors of DC pension schemes, a key distinguishing feature of CDC schemes is that fluctuations in the level of benefits could continue past the point of the pension coming into payment.
The most common form of pension from a DC scheme remains the purchase of an annuity from an insurance company using an individual’s “pot” of money that has been built up under the scheme. This annuity provides a regular annual pension income for the rest of the member’s life and, depending on the options chosen at the time of purchase, may provide a dependant’s pension and annual increases.
The key distinguishing feature of CDC schemes arises because all assets held under a CDC scheme are pooled. As such, members do not have their own “pots” of money from which their pension income will be provided. Instead, any losses and gains arising from the performance of the scheme’s investments will be shared amongst all members. This smoothing effect may result in CDC scheme benefits in payment being increased by less than the target. In extreme circumstances, it is also possible that benefits in payment may be reduced to take account of significant investment underperformance.
Will CDC schemes provide higher levels of benefit than DC schemes?
The level of CDC benefits payable will depend primarily on the levels of member and employer contributions paid to the scheme. However, there are a number of additional factors that distinguish the income-generating potential of similar levels of contributions paid to CDC and DC schemes.
In particular, the scale and pooling of assets by a CDC pension scheme may enable efficiencies to be achieved across a range of areas, including administration and investment costs. In addition, the structure of CDC schemes may allow a wider range of investments, which may generate a higher level of income than investments traditionally held by DC schemes. Steve Webb, the Minister of State for Pensions, has suggested (perhaps optimistically) that CDC pension schemes could provide retirement incomes for some workers up to 30 per cent higher than DC schemes do currently.
A further advantage arises from the lack of a requirement to purchase an annuity for pension provision. The pooling of CDC assets would not require a member to accept a fixed level of income for life, particularly when annuity rates are low. The smoothing effect may also provide members with a degree of insulation from any sudden movements in asset value in the approach to retirement. However, this means it is possible that certain generations of members will subsidise the benefits of others.
What liabilities do employers have to CDC schemes?
Employers of active members of CDC schemes will contribute to the scheme at the rate agreed with the member (for example, a fixed percentage of basic salary). The member may also contribute to the scheme. In this respect, CDC pension schemes are similar to DC schemes.
Unlike DB schemes, the Government proposes that employers will not be liable to make good any shortfall in the scheme’s assets aimed at providing the targeted benefits. Instead, under the current proposals, employers would be liable only to make the specified level of contributions to the scheme without bearing any investment-related risks. However, it is possible that the position relating to funding may change in the future.
Who will establish and run CDC schemes?
In order to benefit from all the anticipated advantages of a CDC scheme, a significant number of members spread across all generations of workers is needed. As such, it is likely that CDC schemes will be established by large employers and trade associations (for example, one of the largest Dutch CDC schemes was established for members of the plumbing trade).
Whilst there is no set structure for establishing CDC schemes, one of the most popular is likely to be the trust. This is in the interests of implementing good governance practices and to enable CDC schemes to be operated by trustees at arm’s length from their sponsoring employers and investment providers.
Why haven’t CDC schemes been put in place before?
CDC schemes have been established and operated in a number of other countries for many years, including the Netherlands and Denmark. The UK Government has previously considered introducing them, but decided against it for a number of reasons. These reasons included questionable levels of investment return, the issues surrounding risk sharing between generations and the need for a constant flow of new members.
The introduction of CDC schemes will also require a significant review of the UK legislative and regulatory regimes. Potential issues arise from the funding and age discrimination requirements and how the concept of CDC schemes will sit alongside the principles governing current DC and DB offerings. These principles include absolute individual entitlements, the inalienability of pensions and the recently announced provisions allowing withdrawal of a member’s entire “pot” from his DC scheme as a lump sum.
Why has the Government decided to introduce CDC schemes now?
Arguably, very little has changed since the UK Government last considered the introduction of CDC schemes in 2008. However, with a focus on facilitating “good member outcomes” and the continuing decline in DB provision, the UK Government is now pressing ahead with CDC. It is not alone in taking these first steps:
- in South Africa, collective pension arrangements are managed by a single board of trustees with a management committee for each employer’s section;
- most of the defined contribution superannuation funds in Australia pool the assets of a large number of members and accept members from all industries and employers (“public offer funds”), although they do not target a particular level of benefit; and
- regulators in Canada are considering the introduction of DB schemes with no guaranteed benefit (“target benefit plans”), albeit not on a collective basis.
Lessons can be learnt from the countries that have already implemented similar types of pension arrangement. In particular, one of the main priorities of the Dutch regulator of CDC schemes in the Netherlands is clear member communications for the purpose of managing benefit expectations. Pensioners need to be able to take a well-considered decision on their pensions. Therefore, the Dutch regulator requires the schemes to provide a clear overview and insight into the level of benefit expectations and the possibility these will not be met.
In addition, the Dutch regulator requires the scheme’s managers to retain ultimate responsibility where investment management has been delegated to a third party. This means for instance that the scheme’s managers must retain an overview of the costs that are payable to the investment manager. The scheme’s managers must also consider the levels of return, risk and costs in respect of the selected investment classes. The Dutch experience has also shown how CDC pension schemes might be structured around the EU’s pensions requirements.
Armed with the benefit of these experiences, it appears that the UK Government now believes it is ready to take on the challenge of implementing this new type of pension arrangement.
The timing of this is perhaps ironic, given that section 29 of the Pensions Act 2011 has just rendered some benefits historically treated as DC, as being more akin to DB. This may make employers wary of any type of scheme which has a purpose of targeting benefits. In any event, we think that any employers who do decide to embrace the idea of collective schemes are likely to be large companies because of the scale required. The market for this type of scheme may therefore be limited.