On 7 October 2024, the Royal Mail launched the UK’s first ever Collective Defined Contribution (CDC) pension scheme, representing a significant step-change for pension saving.

What are CDC schemes and are we likely to see the growth of CDC schemes in the future?

Introduced by the Pensions Act 2021, CDC schemes can be seen as a middle ground between a defined benefit (DB) scheme (which provides a guaranteed income in retirement) and a defined contribution (DC) scheme (where the risk of market volatility and investment underperformance is entirely carried by the member, and there is no guarantee of an income for life). In a CDC scheme, both the employer and employee make contributions towards a collective fund which will be used to provide a target income in retirement. However, the employer does not guarantee the pension income paid to members.

CDC schemes are able to make use of investment pooling, collective risk sharing, and ‘pension smoothing’, discussed further below.

The potential advantages

The trustee of the Royal Mail Collective Pension Plan (RMCPP) has stated that one of the main advantages of this new CDC scheme is its ability to “balance the risk profile of members close to, or already in, retirement with members who are still a long way from retirement”, allowing the trustee to take a longer-term view regarding investments and to target higher investment returns. CDC schemes are able to ‘balance the risk profile’ in a few key ways: by allowing members to share investment risk and longevity risk, and by pension ‘smoothing’ or intergenerational cross-subsidy whereby any decline in value is apportioned depending on how close the member is to retirement. Additionally, as investments are pooled together into one large fund, the trustees will be able to direct investment into more illiquid investments (such as infrastructure) which generally produce higher returns over time.

The potential drawbacks

In attempting to reach a happy medium between the guaranteed income of a DB scheme and the relative lack of risk to the employer of a DC scheme, it could be argued that CDC schemes incorporate some of the negative aspects of both types of scheme.

CDC schemes do not offer the key protections of DB schemes, such as a guaranteed income for life or the employer covenant to make up for any deficit or investment underperformance. In CDC schemes, such as RMCPP, a member’s income may be reduced below the target if the collective fund’s investments underperform or the schemes liabilities outstrip its assets. CDC schemes also limit the autonomy individual members have over their own retirement savings to attempt to produce better outcomes for all members as a collective. Members do not have the ability to make their own investment decisions or select their own funds as they would in a DC scheme.

With regard to pension ‘smoothing’, it has been highlighted that the intergenerational cross-subsidy protections of CDC schemes could disadvantage younger scheme members unless strong controls are put in place. There is also the potential that the complexity of CDC schemes, in contrast to a DC scheme, could hinder member engagement with their pension and lead to misunderstandings.

What next?

The introduction of the RMCPP marks a significant development in the UK’s pension landscape. As the new scheme is in its infancy, it may take many years to assess its success.

While members of a CDC scheme may be comforted by a target income for life, the lack of control over investments and the potential for intergenerational unfairness may prove off-putting for some. It is encouraging, however, that an alternative to DC schemes (which in many cases do not provide adequate income in retirement) and DB schemes (which are generally seen as too risky and costly by private sector employers) has been created.

Industry commentary suggests that there is a desire for CDC schemes to be available more widely. Just this week the DWP announced it is consulting on the extension of the CDC framework to unconnected multi-employer schemes (the current CDC regime only applies to single or connected employers). The consultation closes on 19 November 2024.

Time will tell if CDC schemes will become a viable ‘third way’ of saving for retirement for employers and members. Their success and growth will most likely depend on the ability of trustees to effectively manage the challenges posed and offer members a stable and predictable income in retirement.

To find out more about CDC schemes, please get in touch with your usual contact in the pensions team.

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