CDC: the future of UK pensions?
The ICAS Pensions Panel supports the laudable aims of the Government’s proposals for Collective Defined Contribution (CDC) pension schemes.
Questions remain, however, about whether there will be sufficient appetite among employers and savers for CDC. Moreover, there will be significant challenges in establishing a suitable legislative and regulatory framework.
The introduction of CDC was discussed as a possible solution to defined benefit (DB) funding challenges during our Challenging Conversation on pensions.
UK plans to introduce CDC
Government proposals on CDC, set out in a consultation document published by the Department for Work and Pensions (DWP), are an evolution of the Coalition Government’s 2013 proposals on Defined Ambition (DA) pensions.
CDC schemes already operate in several countries, including Canada and the Netherlands, and work on the basis that contributions are pooled and invested with the intention of delivering a target level of income in retirement.
Royal Mail and the Communication Workers Union (CWU) reached agreement in principle, early last year, to work towards introducing a CDC arrangement for all Royal Mail employees: this has been the impetus for developing the current proposals. The Work and Pensions Select Committee has also recommended that the Government works quickly to legislate for CDC.
Care needs to be taken in drafting, including subsequently revising, CDC legislation to ensure that it cannot be interpreted as giving rise to any type of guaranteed benefit. This would lead to re-classification of such benefits as DB benefits and presumably, these would need to be protected by the Pension Protection Fund. Such a situation arose following a change in legislation in July 2015, when some Defined Contribution (DC) benefits had to be reclassified as DB benefits.
Pensions freedoms incompatible with CDC?
The ICAS Pensions Panel believes that the pensions freedoms may not be compatible with the risk sharing aspects of CDC. The freedoms allow retirees who have a DC pot to use their pension savings to purchase a drawdown product. Savers with significant pots may, therefore, be more inclined to move away from risk sharing and towards relying on their own pension pot plus the State Pension for their retirement income.
Nevertheless, exercising the freedoms could lead to poor investment decisions at or after retirement, resulting in inadequate income in the later years of retirement: CDC schemes may be a means of reducing this risk.
Transferring DC or DB to CDC
Where an employee is thinking of transferring a DC or DB pot into a CDC scheme, risk warnings and, where appropriate, independent financial advice will be vitally important as it is in the best interests of the employee (and the employer) to understand the relative merits of leaving funds where they are or moving them.
If transfers out can be prevented by the trustees in certain circumstances, this will also need to be explained adequately to any employee seeking to transfer funds into a CDC scheme. The regulatory framework for regulated financial advice will need to be updated to reflect CDC rules on transfers.
Setting contributions for auto-enrolment
Applying a cost of accrual test to contributions for auto-enrolment purposes could be excessively complex and therefore it may be necessary to apply the minimum contribution test, currently used for money purchase schemes. This means policy-makers may have to accept the related risks of this test, in the context of their objectives around auto-enrolment and retirement saving.
We believe that the approach to contributions for auto-enrolment purposes is an area requiring further detailed consideration.
Cost could be a deterrent
The Pensions Panel understands the desire for CDC schemes to be limited, initially, to single or to associated employers and accepts this approach as a reasonable way to introduce CDC.
However, given the need for scale and the likely initial set up and on-going running costs (for example, annual actuarial valuations), there could be a limited appetite among employers to move away from existing DC arrangements, especially those participating in DC master trusts or providing employees with a contract-based DC arrangement.
Member communication is vital
The quality of employer communication with employees about their pension offering is a key issue. The inherent complexity of CDC means that additional effort will be needed by employers to ensure that employees understand the risks and rewards.
This brings to the fore the important role that employers have in a DC environment in relation to financial education, including the many ICAS members who are also employers.
CDC and pension tax reliefs
Greater consideration of the tax implications for savers is needed around the design of CDC and it may be necessary to do this in the context of some wider pensions tax issues. For example:
- DC master trusts can operate on a relief at source basis or a net pay basis. Net pay arrangements have been criticised as workers eligible to be auto-enrolled who are not taxpayers do not receive the basic rate relief top up which is available to equivalent workers enrolled into schemes operating on a relief at source basis. This means such workers in net pay arrangements will have relatively smaller pots. The sums involved at the moment are small but will increase in future as the personal allowance for income tax increases and minimum auto-enrolment contributions increase. Potential changes to the scope of auto-enrolment to 18 year olds and the removal of the minimum income threshold on auto-enrolment contributions would further impact on relative pot size.
- The lifetime allowance is assessed differently for DB schemes than for DC schemes, with the effect that a DB scheme member assessed as having reached the lifetime allowance would have a higher income than someone with only DC savings who had reached the lifetime allowance. This is inherently unfair and a decision would need to be taken as to how a CDC pot would be measured vis-à-vis the lifetime allowance.