Retirement plans get a new look
Collective defined contribution (CDC) is a hot topic in the pensions industry, with many enthusiastic supporters, including the Minister for Pensions, Torsten Bell, extolling the potential superior member outcomes. However, there are sceptics, and those with more conspiratorial views argue that CDC is just “actuarial voodoo”.
A useful way to think about CDC’s benefits is to imagine a gardener who plants a single fruit tree, representing your pension savings. You invest steadily over time, and when you retire, you start to live off the income it produces.
Being reliant on just one tree comes with risks. If the tree does not grow well or suffers from disease, there may be too little fruit. You might be hesitant to use a powerful fertiliser if there’s even a small risk it could kill the tree.
This is a useful way to think about the challenges of a typical defined contribution pension. Individuals are responsible for their own investment decisions, bearing the investment risk, and managing the risk of outliving their savings.
Alternatively, imagine you join a gardening club, where a sapling is planted, but instead of having your own tree, you get a share of the entire orchard. Everyone contributes by watering the trees, and in return, the club aims to give you a steady supply of fruit from a set date for the rest of your life.
There are clear advantages to the orchard approach. You are not dependent on a single tree – if one tree has a bad year, others in the orchard can make up for it. As new members join, planting more saplings, the orchard continues to grow and replenish itself over time.
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Critically, the amount of fruit distributed to each member is based on how long the average member is expected to live. But, as some will live shorter-than-average lives and others longer, retired members know they can keep getting fruit for life.
For many, CDC could be a better way to manage the uncertainties of retirement, as it redistributes risk, rather than eliminating it. It’s not magic, and it’s not perfect, but it could be a more predictable and sustainable option.
One of the key benefits of CDC is that it allows for a more efficient use of resources, as the risk is shared across members and spread over time. This means that a CDC can take on more risk than a typical defined contribution pension, but any windfall return is shared by all.
It’s also worth considering that CDC schemes share longevity risk, which ensures an income for life, but in the event of an early death, the residual capital is not passed to your estate. This can be a significant trade-off for some individuals, and it’s essential to weigh the pros and cons before making a decision.
In practice, CDC means that individuals can benefit from a more stable and predictable income in retirement, without having to bear the full risk of investment decisions. This can be particularly beneficial for those who are not financially savvy or do not have the time to manage their investments. The Minister for Pensions, Torsten Bell, and other supporters argue that CDC is a more stable option. CDC does not eliminate risk, but it does redistribute it. The collective defined contribution plan is a type of pension plan that pools resources to provide a more stable and predictable income in retirement. According to the report, this type of plan can be a better option for many individuals, as it allows for a more efficient use of resources and a more stable income in retirement, similar to a collective growth model.
