[SPONSORED COPY]
These new pensions should help DC members turn a retirement fund into a lifelong income stream. But BlackRock’s head of DC solutions, EMEA, Ben Rees says success will depend on clear communication, robust governance and careful scheme design.
At a high level, what problem is CDC trying to solve in the UK pension system?
The way UK workers save for retirement has fundamentally changed in recent decades, moving away from defined benefit (DB) to defined contribution (DC) pensions.
DB schemes delivered a predictable retirement income for workers, but proved expensive for many employers, who were financially liable for shortfalls, should investments underperform, or assumptions around longevity turn out to be incorrect.
In contrast, it is the employee who carries the investment and longevity risks with DC.
Auto-enrolment has also brought millions of additional savers into DC workplace pensions. AE has been successful in boosting pension participation, helping employees accumulate savings for their retirement.
But it has not solved the challenge of converting this pot of money into a reliable income once employees stop working. Pension freedoms have exacerbated this problem, with the vast majority of employees now choosing to keep pension funds invested at retirement, rather than buying an annuity.
The new CDC pensions are designed to address this challenge, offering employees more certainty and stability when it comes to retirement income, but without burdening employers
with the cost or risks of providing guaranteed DB benefits.
Under a CDC arrangement contributions remain fixed, as they are in DC, giving employers greater certainty around future pension costs. But employees are saving towards a pension income, rather than a pot of money.
This key distinction (when compared to DB) is that this is a target income, rather than a guarantee. Scheme members will get a pension for life — but this payment can rise and fall, with the exact level dependent on the scheme’s investment returns and mortality experience.
CDC schemes are structured to pool both investment and longevity risks, meaning individuals aren’t left to manage these on their own. In theory this should lead to higher payments when compared to standard annuity rates, while still offering a degree of certainty that people won’t outlive their pension.
What are the different types of CDC?
There are currently two main models: whole-of-life CDC and retirement-only CDC (R-CDC).
Whole-of-life CDC means members contribute into this collective arrangement throughout their careers. The scheme then pays a retirement income directly once they stop working.
Retirement-only CDC works differently. Members build up assets in a traditional DC arrangement during their working life, then choose at retirement whether to transfer some or all of their pension pot into a collective income arrangement. That offers greater flexibility with members able to retain part of their pension in drawdown, should they want, while allocating another portion into CDC for income stability.
This retirement-only model may fit more naturally into the existing UK pensions infrastructure, as providers could bolt it onto current DC master trusts as a post-retirement default solution.
However, whole-of-life CDC may be able to deliver some advantages because this risk-sharing operates over a much longer time-frame. This should enable schemes to hold larger allocations to growth assets, potentially enabling them to deliver a higher income stream in retirement.
As the UK regulatory framework evolves, where do you see CDC playing its biggest role?
The regulatory framework is now moving beyond the single-employer model created for Royal Mail. The next major step is the introduction of multi-employer CDC schemes for whole-of-life arrangements. Legislation to enable this is included in the new Pension Schemes Act.
We may soon start to see multi-employer CDC schemes focused on specific industries or sectors. This should help address the UK’s persistent small pots problem — by keeping people in the same pension arrangement when they move jobs within their sector.
Currently the Government is also consulting on retirement-only CDC arrangements. These are likely to gain traction with forthcoming regulation that will require workplace pension providers to offer a default retirement income solution. A number of providers are expected to offer R-CDC as their default pathway for members at retirement.
While we may see both whole-of-life and retirement-only CDC options in the market, they are unlikely to replace DC altogether. Instead they are likely to be options offered alongside conventional DC and drawdown structures, giving greater choice for employers and employees.
How does investment and longevity pooling in CDC change the trade‑off between income certainty, risk‑taking and individual choice for members?
In conventional DC schemes, members are usually “de-risked” as they approach retirement. Equity exposure is gradually reduced and replaced with bonds or other lower-risk assets to protect the value of their pension pot before retirement.
With CDC members are pooled together, with the scheme investing across these different generations, and an investment strategy built around the average age of scheme members. Provided younger members continue to join, this is likely to remain relatively stable, allowing the scheme to maintain a higher allocation to equities and other growth assets, when compared to traditional DC arrangements. This is one of the reasons many CDC models project higher retirement incomes than traditional DC arrangements.
However the flipside of this is that members lose some flexibility over investment choices, withdrawal decisions and inheritance outcomes, when compared to DC arrangements. They also have to accept a degree of variability in retirement income, as these are not guaranteed pensions. However, this variability will be less than they would experience in a drawdown arrangement.
What does the international experience tell us about how CDC might work in practice in the UK?
The Netherlands and Denmark are frequently cited as examples of successful collective pension systems. Both countries consistently rank highly when it comes to pension adequacy and sustainability measures, and both have long histories of collective investment and risk-sharing structures.
But it’s important to remember both models operate in very different environments, where there are higher levels of mandatory participation and significantly greater market consolidation. The pension system in the Netherlands, for example, has large industry-wide pension funds with substantial in-house investment capabilities. This has enabled sophisticated investment strategies, including significant allocations
to private markets and extensive internal investment expertise.
The UK, by contrast, has a more fragmented market and a stronger culture of individual choice following pension freedoms.
Nevertheless, there are important lessons we can learn from these countries. The first is the importance of effective communication. Members must clearly understand that CDC pensions are targets, not guarantees. The second is around governance and fairness. Because CDC relies on intergenerational risk-sharing, scheme design must avoid systematically advantaging one cohort over another. Finally, the international experience reinforces the importance of scale. Larger schemes are generally better positioned to manage long-term investment strategies efficiently and absorb market volatility.
What are the key design and governance decisions trustees and sponsors need to get right when setting up a CDC scheme?
First and foremost, schemes need to think about what they are trying to achieve by setting up a CDC. There is an inherent trade off between maximising long-term income and minimising variability. A higher-risk investment strategy may produce better retirement outcomes on average, but it also increases the potential volatility of member benefits.
Trustees therefore need to decide whether they prioritise higher expected pensions
or greater income stability. That choice then drives everything else: investment strategy, actuarial assumptions, communication and governance structures.
It is also important that there is a high level of transparency around investment strategy and actuarial assumptions. This is because CDC requires much closer integration between actuarial and investment decision-making than many traditional pension arrangements.
Because member outcomes directly depend on investment performance, assumptions about future returns become highly sensitive. If providers use overly optimistic assumptions, they risk overstating future pension incomes. But if assumptions are too cautious, one generation may unfairly subsidise another.
UK providers will have a degree of flexibility when setting their own assumptions, although there will be regulation around this. For this reason trustees and providers will need to demonstrate how their assumptions
are constructed, how investment strategies support them, and what level of variability members could experience.
Providers launching CDC will need external expertise across a number of areas, such as the expected return modelling, long-term portfolio construction, risk management and private market allocations.
BlackRock has considerable experience across these and other areas, and for the past 20-plus years has run mandates for collective pension arrangements in countries such as the Netherlands. This international experience is likely to prove valuable when designing investment strategies capable of supporting long-term collective income objectives for new CDC arrangements in the UK.
