Collective defined contribution pensions: how will they work and could they boost your pension pot?

Collective pension schemes could be arriving in the UK promising higher returns and lower risk - but how would they work and who will be able to get one?

A new way of saving for your retirement

The way we save for retirement could be about to change with the introduction of collective pension schemes.

Popular in the Netherlands, these schemes allow workers to pool together their retirement pots and lower their overall risk.

The Government launched a consultation into ‘collective defined contribution’ (CDC) pensions this week, and Royal Mail has already confirmed it will offer them to its workers when introduced.

The design of these Dutch-style pensions is seen as a combination of the ‘gold-plated’ final salary schemes and the less generous but more common defined contribution schemes.

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As risk is spread out among everyone who pays into the scheme, the fund is able to invest in a wider-range of assets.

Therefore people should receive higher amounts when they retire then they do with a defined contribution scheme.

However, instead of receiving a guaranteed income on retirement, workers are given a ‘target’ amount they can expect to get, which can rise and fall depending on the performance of the fund.

Guy Opperman MP, parliamentary under-secretary of state for pensions and financial inclusion, said: “The UK has a world-class occupational pension system – but I believe that there are always opportunities for further innovation which can be made for the benefit of savers and business alike.

“A robustly designed and appropriately regulated CDC regime is one such opportunity.”

Here we explain how they work, the difference between our current pension schemes, the main pros and cons and when they’re likely to be introduced.

How do collective defined contribution pensions work?

All members of a CDC pool their money together and it is invested collectively.

Those in the scheme are given a target amount they can expect in retirement.

This is based on how much money is paid in, how much money there is collectively for all members and the performance of the investments.

If the collective fund rises, or falls, the target income is adjusted, both for those saving for retirement and those who are already retired.

The pension pot is invested in a wide range of assets for a lower cost than an individual could achieve because the costs are shared between members.

Unlike with defined contribution schemes, members aren’t able to pick investments on an individual basis or get the choice of how to convert their pot into an income when they retire.

How do they differ from other pension schemes?

The two main pension schemes in the UK are final salary schemes, which are now extremely rare and almost non-existent, and the more popular defined contribution scheme.

Final salary schemes provide a set level of income in retirement, which is usually a percentage of the employee’s salary just before retirement and based on the number of years they have worked.

Defined contribution schemes are the most common type of pension and have been widely-adopted by most firms in the UK.

They are usually made up from employee and employer contributions, or just employee contributions via a self-invested personal pension (SIPP) if not, and workers are in control of what their money is invested in and how they receive this when they retire.

CDCs are expected to provide a third option to savers.

Steve Webb, director of policy at insurer Royal London, says the current schemes “swing between two extremes.

There’s the traditional final salary pensions, where the employer bears all the risks around delivering the final pension, and the newer ‘defined contribution’ arrangements where workers build up a pot of money and have to handle the ups and downs of how well their investments perform.”

He adds: “Collective schemes are designed to be a ‘half-way house’ which may offer more predictable outcomes for members but with lower costs and risks for employers.

“Such schemes are widely used in other countries and try to achieve better outcomes by operating at scale and by smoothing the ups and downs of the stock market between a large number of members over time.”

What are the main benefits of CDCs?

In theory, as members’ money is pooled together, there is less risk to individual pension pots.

These schemes may also be attractive to savers who aren’t comfortable picking their own investments or making decisions about their retirement income.

It’s believed the CDC can invest in riskier assets than an individual pot at a lower cost, because the cost is shared among all members.

This means the returns and therefore the retirement income should be higher than it is with current defined contribution schemes.

Tom Selby, spokesperson for investment firm AJ Bell, says: “Many advocates of CDC believe that, because the scheme is able to hold riskier assets for longer, it can deliver better returns – and consequently bigger pensions.

“The argument goes that members do not need to ‘derisk’ into cash as they approach retirement because all assets are pooled, meaning they can potentially benefit from extra investment growth.

What are the drawbacks?

Some critics of CDCs say it is already possible to invest in riskier assets to get potentially bigger returns on retirement with a defined contribution scheme.

Another potential drawback is the lower levels of flexibility.

Members don’t have the option of picking individual investments and the entire system is based on a set retirement income being received at a certain time.

Tom Selby explains: “The structure is arguably based on an old world where savers expected a fixed level of income throughout retirement.

“While this is undoubtedly desirable for some, many now prefer to adjust their income to meet their needs.

“Perhaps most importantly, people need to remember that CDC won’t offer guarantees.

“That means, in the event investments underperform expectations, pensions of all members could be cut – including those of people who are already drawing an income.”

Nathan Long, senior analyst for investment firm Hargreaves Lansdown, echoes this sentiment.

He says: “In practice, their design makes them far better suited to working trends 30 years ago than today’s modern, flexible working patterns.

“The reality is that far more people are now working until they are older.

“With the state pension being pushed back, people living longer, and savings levels having been too low for too long, this trend looks set to continue.”

There is another point to consider, which is how a CDC scheme – whereby income is set depending on contributions – works within the frame of UK’s pension freedoms.

These allow anyone over the age of 55 to take out their entire pension pot and pay no tax on the first 25%.

But it’s unclear how someone would be able to do this without it affecting the target income of other members of a CDC.

In the consultation, the Government has said it will need to look into how people will be allowed to transfer money in and out.

It also says it will look into lowering the cost for younger workers and how this would work.

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When will they be introduced in the UK?

It’s very early days at the moment as the Government consultation into how CDCs would work in the UK has only just been launched.

It is asking for responses to be sent in by January 16th and after this date the initial proposals and responses will be published.

Royal Mail Group is currently the only firm to commit to the scheme and some believe CDCs will only be used to replace expensive defined benefit schemes, where they still exist.

Carolyn Jones, head of pensions products for investment firm Fidelity, comments: “CDC could be an attractive solution for large defined benefit schemes that need to address the ever-increasing costs of defined benefit.

“Beyond this, it is difficult to see employers who have already embraced defined contribution transitioning to CDC.”

If CDCs are introduced more widely in the UK, and how in practice this will happen, won’t be known for some time.

The Government has said it will introduce the necessary legislation “as soon as Parliamentary time allows” but given the pace that these things usually move at and the number of questions over how CDCs would work, it’s not likely to be coming any time soon.