Collective Defined Contribution – another pensions headache?
In 2010, completely out of the blue, the pensions industry got a minister who was actually interested in pensions. Steve Webb (now Sir Steve Webb) was a Liberal Democrat MP who had written and thought about pensions for some years, and knew an awful lot more than your average pensions minister.
Webb noted that the problem was that there were two types of pensions – defined benefit, that provided well for employees but beggared the employing business, and defined contribution, which were utterly predictable for the business, but far too risky for the employees. Really, what we needed was something in the middle, a concept that was quickly tagged by someone in communications as “defined ambition”.
Finance directors and businesses largely lost interest once it became clear that there would be no compulsion to move to this halfway house. Those who had closed their defined benefit schemes and moved to defined contribution were not going back whilst they still had deficits on their balance sheets. Those who were hanging onto their defined benefit schemes were only going to go through the pain of closure if they got to the safe haven of defined contribution. Defined ambition was unlikely to fly. The legislation to allow these schemes to be set up was passed in the Pension Schemes Act 2015, but still requires a government regulation to bring it “into force” and make it law – another Liberal Democrat idea that everyone has forgotten, like proportional representation. Forgot about, that is, until now. The Work and Pensions Select Committee has started considering whether one of these defined ambition options, Collective Defined Contribution or CDC, may be a good idea after all. Does this mean businesses should be considering them? Should they be worried?
The idea of CDC is to allow the sharing of risk amongst scheme members. One of the fundamental problems of defined contribution pensions for the individual is that the risk is so stark. If you retire the week that the stock market crashes and gilt yields fall, your pension income is forever a lot smaller than the pension drawn by Steve, who worked next to you and retired a week earlier. CDC tries to ameliorate this challenge by sharing the risk between the investors in the scheme. So, Steve’s pension isn’t quite so good, so that there are funds to ensure that when you retire after the crash, your pension isn’t quite so bad. The concept also allows pensions to fluctuate over time – if Steve and you and everyone else is living longer, the pensions for everyone can reduce, allowing the initial pension to be higher, as there is no guarantee of income level on offer.
It should be obvious from this why a CDC model is attractive to employers. The intention is that the employer is not under any obligation to top up benefits – there is no deficit, no contribution schedule to negotiate, no reference in business accounts except in relation to the set contributions. The employer simply makes the same contributions each year and it is up to the scheme to work out what that means for the pensions members receive. Effectively, the business can provide its employees with something significantly better from a risk point of view than defined contribution, but with no extra costs or liabilities.
However, reality may be a little different. The biggest challenge with CDC is the complexity of some of the concepts involved, which means that employees are often unclear about the terms, and may in any event forget the negatives in the future. The Dutch model, on which CDC is allegedly based (although most Dutch pension experts can explain, at great length, why their system is very different), did allow benefits in payment to be reduced if asset values fell. Following the financial crisis of 2007 onwards, the level of pensions in payment in some Dutch schemes did fall, causing some outrage from the pensioners, who had of course not remembered (or ever realised) that this might happen.
So, in practice, might CDC not in fact result in businesses being pressured to shore up the scheme when returns fall and costs rise? A legal obligation is not the only reason that businesses make pay outs to employees and former employees, and reputation and employee relations could mean that such a scheme may cost dear. Perhaps it is the uncertainty around this, more than anything else, which makes CDC unattractive whilst defined contribution is still available, with none of these risks attached.
In addition, the history of defined benefit schemes shows us that legal obligations can be imposed by governments – most defined benefit pension schemes were established to allow the business to decide unilaterally to make no further payments, but the last 20 years of legislation completely overrides that agreed legal position. Similarly, governments might, in the future, impose obligations on business to fund CDC, and there can be no guarantee that they will not.
So, in the future, how would a business feel about buying a target with a CDC scheme? It would clearly not involve taking on the liability intrinsic to a target with a defined benefit scheme, but there could be future compulsion to contribute, either because of employee relations pressures or even changes to legislation, and such risk, though less certain, is less quantifiable. If there is a move towards CDC, this could add more questions and less certainty for an acquirer, unable to be sure if the target has quite the same lack of obligation that it would with a straight defined contribution scheme.
At present, CDC not expected soon, if at all. Our present regulatory system does not allow for it, until and unless government brings it into force. If they do, that won’t require CDC to be used and it is unlikely to be popular. That said, the government has used the automatic enrolment legislation to improve standards in defined contribution schemes and it is always possible for this to be used to force employers to use CDC at some point in the future. All this remains speculative – the fact that the select committee is looking at this does not necessarily note any change in government policy, and any future for CDC is several years away at least, for which finance directors may, in the end, be rather grateful.
Rosalind Connor, Partner
This article was published in Financial Director
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