Understanding collective defined contribution schemes: a path to effective design

In the ever-evolving landscape of pension solutions, collective defined contribution (CDC) schemes represent a promising innovation. Designed to offer a stable retirement income without the volatility associated with individual defined contribution (DC) plans or the financial risk to employers that was a key characteristic of defined benefit (DB) plans, CDC schemes are gaining traction.

This blog offers an overview of a new report by the IFoA’s CDC Working Party on CDC scheme design, highlighting key principles and considerations. For those seeking an in-depth understanding, the full report provides more detailed insights and guidelines.

What is CDC?

CDC schemes combine elements of both DB and DC plans. Contributions are defined, with no additional liability for the employer. Longevity risk is pooled to provided members with an income for life, but benefit levels will vary based on the scheme’s financial performance and longevity experience.

Key design principles

The IFoA report outlines several principles for effective CDC scheme design that are likely to apply in most cases:

1. Clear objectives: Establishing well-defined goals from the outset is essential. Objectives guide the selection of design features, ensuring the scheme meets the desired balance between cost stability and income security.
2. Simplicity: A straightforward design facilitates easier operation, comprehension, and communication. Complexity should only be introduced if it significantly enhances the scheme’s alignment with its objectives.
3. Comparison with existing options: CDC schemes should offer clear advantages over current pension solutions. This comparative analysis ensures the scheme’s value proposition is compelling.
4. Trade-offs and compromises: No design is perfect. Balancing trade-offs to minimise negative consequences is crucial, and sometimes, revisiting objectives is necessary if an acceptable balance cannot be achieved.
5. Fairness and cross-subsidies: Designs must be equitable, with any cross-subsidies (for example longevity pooling) clearly justified and communicated. Fairness is paramount to maintain stakeholder trust.
6. Scenario testing and modelling: Analysing how the scheme reacts to various circumstances through robust modelling helps ensure it remains viable and meets its objectives under different conditions.
7. Sustainability: Long-term sustainability is critical. The design should ensure the scheme remains cost-effective and viable, particularly concerning member scale and contribution rates.

Design options and implications

The report then delves into 10 key design aspects, each with significant implications. In summary:

1. Pricing new accrual: There are different methods for converting contributions to pension. Fixed accrual rates offer simplicity but can lead to cross-subsidies, whereas variable rates can be more equitable but complex.
2. Setting assumptions: Assumptions for pricing and valuations need to balance transparency, accuracy, and simplicity.
3. Investment pooling: Pooling investment returns can smooth income variability but may introduce intergenerational cross-subsidies.
4. Longevity pooling and mortality underwriting: Sharing longevity risk is fundamental to CDC schemes. Options for death benefits and mortality underwriting should be carefully considered to maintain fairness and attractiveness.
5. Variable pension increases: Annual adjustments to pensions ensure the scheme remains appropriately funded. However, there are several calculation approaches to choose from, each with different trade-offs. In addition, offering different types of increases, for example inflation linked and fixed, can accommodate different member needs but complicates communication and administration.
6. Risk buffers: Holding back some assets as a risk buffer can help facilitate more stable income levels but introduces intergenerational fairness issues. The size and management of this buffer are critical.
7. Wind-up triggers and protection mechanisms: Plans for potential scheme wind-up ensure member protection and scheme continuity. Options can include continuing to run a closed scheme, converting benefits to individual pots, or transferring to another CDC arrangement.
8. Member options: The range of options for members can vary, from minimal choice in single-employer scheme to extensive options in multi-employer schemes, including different target pension increases and death benefits.
9. Leaving service benefits: Determining the benefit entitlement for members leaving the scheme, typically deferred pensions, needs to be considered to ensure fair treatment and consistency with active members’ benefits.
10. Insured elements: Schemes may decide to insure some elements of the benefits either through investments or a specific contract. Cost and availability will be a key factor in deciding what elements to insure.

Conclusion

CDC schemes offer a balanced approach to retirement income security and cost stability. The IFoA’s report provides a summary of the important considerations for designing effective CDC schemes, with a focus on actuarial aspects.

Read the full report