As of 7 October, the Royal Mail Collective Pension Plan will launch for Royal Mail employees with over a year’s service. It’s an achievement for all involved and is the first time in decades a new style of pension scheme has been launched in the UK. Embracing collective funding and members all sharing in the gains and losses of investment markets, CDC schemes borrow from both traditional DB and DC schemes. This includes an annual pension and lump sum entitlement on retirement from DB, but members bear the investment risk on their benefits from DC. If DB and DC schemes are on opposite sides of the spectrum, CDC sits near the middle, perhaps leaning towards DC with the risks that members still take.
What if legislation promoted the development of further DB/DC-style schemes, taking the best parts of both DB and DC to create schemes that work for all? The adequacy of UK DC pension provision is an industry-wide challenge, with historically generous DB legacy arrangements forming a decreasing part of retirement provision, instead replaced by insufficient DC pension pots, leading to a potential erosion of standards of living in retirement. The industry is looking at maximising output from DC arrangements through illiquid assets and sensible decumulation options, but it seems inevitable that higher contributions through the expansion of auto-enrolment will be in the future.
Could the answer instead lie in embracing historic aspects of DB? It’s not hard to envision a win-win-win for employer, member and government. Employer takes on manageable risks with some other form of incentive from the government (lower mandated contributions, NI rebates, etc), the member achieves a better retirement outcome without the abundance of choice on what to do at retirement and there is less reliance on the government to cover future state retirement provision.
With a lot of untapped potential in the middle of the UK pensions scheme design spectrum, the important question is what tweaks can be made to current scheme design that makes a ‘DB-lite’ scheme appealing to all stakeholders involved. Below are a few examples that I think could be attractive.
- CDC with a no-reduction underpin on pension increases – collective funding with limited downside risk, with employers absorbing the small risk.
A big challenge of CDC is the years of poor financial markets, and having to tell members that their pension is reducing. If an employer provided a guarantee against this, it resolves a big challenge of CDC. Whilst CDC is currently designed to have no surplus or deficit, legislative change could allow for deficit reduction contributions over an appropriate period of time to plug a deficit, which would stop when the scheme is funded well enough to provide increases again. This wouldn’t be far off from DB schemes in deficit, except the ability to have nil pension increases whilst in deficit which would limit the downside risk for employers. For a whole of life scheme with a long duration, it is very unlikely that an underpin will bite, and the impact will be reduced in any event.
- PPF-level benefits on retirement – guaranteed income above annuity pricing, with the PPF as a safety net.
The conversion of say AVCs into a DB pension is an uncommon but feasible option for UK DB schemes. Converting DC benefits at-retirement to a DB pension which provides PPF-level benefits would likely give employees an outcome above annuity purchase, but maintaining a strong level of certainty given the scheme would be underpinned by the PPF. A theoretically strong option, however, is built on moral hazard and is certainly an area TPR will be keeping a close eye on.
- Varying DB benefits – mixture of risk sharing of member and employer, getting the balance right with simplicity, costs and member protection.
DC benefits have long had a flexibility argument over DB, with annuity purchase allowing members to flex the characteristics of a lifetime pension to match their circumstances. What if legislation allowed members to flex their DB benefits at the point of retirement? This is already possible to an extent with limited restrictions for certain schemes, through pension increase exchanges on pre97 benefits and spouse percentage purchasable at-retirement. What if a member didn’t need a spouse pension, or wanted to trade off all of their pension increases for a flat higher pension on retirement? Schemes could trade typically-expensive risks in inflation and longevity for members getting a benefit that best meets their needs. There are a wide range of scheme designs that have various trade-offs that should fit well along the scheme design spectrum.
Whilst the above examples represent very different scheme designs, they all benefit from the power of size and scale. What’s clear from the King’s Speech is that the government are prioritising consolidation within the pensions industry, and the above examples would be even more appealing in a consolidated pensions environment.
With change comes opportunity, and the launch of CDC symbolises further opportunity to embrace different scheme design to meet the challenges of future pension provision. The pensions industry will rise to the need to build better pension schemes for the future, but the first step sits with the government, which needs to be bold and ambitious in building the legislative foundation for these scheme designs to flourish. Our call for the government is to embrace the opportunity they have and leave a lasting legacy for future pension provision in the UK.
Mark Stansfield is Actuarial Consultant at Hymans Robertson
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