News & analysis TO CDC OR NOT TO CDC
Could Collective Defined Contribution schemes generate higher returns than a DC plan? Mona Dohle takes a look.
The grass is always greener on the other side. With the sum- mer holidays approaching and fatigue over Britain’s economic decline settling in, some Brits might be looking across the channel to France where inflation is almost half that of the UK. Or to Germany, where you can travel across the country for €9 a day, or to Denmark and the Netherlands, which have estab- lished Collective Defined Contribution (CDC) schemes. The latter is a slight exaggeration. Not many British citizens will be losing sleep over the perks of pooling pension risks, but policymakers are. From August, trustees can apply to become a CDC scheme, where the investment management is pooled and the risk is shared with the members.
CDC is also described as defined ambition because schemes offer members an aspired target income, which is then adjusted , subject to market conditions. Given the decline of defined benefit (DB), and that defined contribution (DC) schemes will struggle to generate a sufficient income for many members, this could be a compromise.
Slow take up With most DB schemes closed to new members, it seems unlikely that they will be the driving force behind CDC. Another complication is that by converting a final salary scheme into a CDC structure, the sponsor would be reneging on past pension commitments, a step that would likely be chal- lenged in court. Having said that, CDC schemes in the Nether- lands evolved out of DB.
In contrast, CDC could appeal to DC members because it offers greater certainty of income. But under the current setup, the CDC application process is only open to single-employer schemes, excluding master trusts. Consequently, only the Royal Mail’s DC scheme is expected to apply for CDC authori- sation in the foreseeable future.
While some countries, including Denmark and Canada, have implemented CDC as the first, state-sponsored pillar of pension provision, in the UK it will only be considered for the second, occupational pension pillar. This is the approach followed in the Netherlands, where participation is mandatory in order to build the required economies of scale. In the UK, participation will be voluntary, which could prevent CDC from taking off.
Mastering trust The Department for Work and Pensions is consulting on whether CDC should be extended to master trusts. But for CDC schemes to be successful, they have to appeal to larger
8 | portfolio institutional | July–August 2022 | issue 115
master trusts, believes Simon Tyler, Pinsent Masons’ legal director. “CDC schemes work best when mortality risk is pooled across as large a population as possible, and when that population includes members of all ages – indeed, mortality pooling is the main selling point of a CDC scheme over a tradi- tional DC scheme.”
Another advantage of CDC is that unlike DC, they manage the decumulation stage collectively which means individual mem- bers are not exposed to the risk of annuitisation timing. Unlike in DC, CDC schemes do not tend to offer a customised investment strategy to members. Depending on the form of CDC being implemented in the UK, this might mean mem- bers will not have a say in the level of investment risk they want to take. In exchange, CDC members could benefit from greater economies of scale. Moreover, engagement on auto-enrolment default funds is generally low. But this could change if CDC schemes were booking significant investment losses, which given the market outlook is possible. It also raises questions about access to ESG or Shariah-compliant investment strategies. So far, at least one master trust, Smart Pensions, has expressed an interest in offering a CDC scheme. But for government- backed Nest, the UK’s largest master trust, CDC is not an option. Due to its size and government-backing, it is barred from entering the decumulation market.
Equity heavy
If CDC is to take off in the UK, and assuming that master trusts will be a driving force behind it, then such strategies are likely to be equity heavy. Research suggests that CDC schemes could offer a better investment performance than DC schemes. A paper by Iqbal Owadally, Rahil Ram and Luca Regis pub- lished last year in The Journal of Social Policy, uses simulation to assess the potential investment performance of CDC in the UK compared to that of DC schemes. The research looks at the investment performance of a DC strategy that is invested in UK equities, a CDC UK equity strategy, a gilts strategy and a DC lifestyle strategy which shifts from equity to gilts. The authors conclude that over a 25-years, factoring in different market environments, the CDC plan outperforms the DC strat- egies. While this is to be expected, CDC also marginally outper- forms a DC equity-only strategy, offering a return of 32.3% com- pared to 31.8% at almost half of the volatility (9.1% compared to 17.4%). However, the authors note that while CDC can offset potential losses in an equity downturn, it also means members will sacrifice some returns in a booming equity market. The bottom line is that CDC could improve on DC’s invest- ment performance. But important questions on investment choice, valuation metrics and how to build scale need to be answered.
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