Out-Law Analysis 5 min. read
18 Sep 2023, 9:59 am
The UK government said in a set of July 2023 Mansion House proposals that it would allow commercial UK pension schemes, including master trusts, to provide collective defined contribution (CDC) benefits in retirement.
CDC decumulation-only arrangements (CDCDAs) are intended to share investment and mortality risk during retirement with the aim that this leads to higher pension payments.
Like any CDC arrangement, savers will bear the risk of reduced payments if investments underperform. The hope is that with most of the UK population paying into master trusts during their working lives, it might be possible to create CDC pools within those trusts for retirement.
There is currently an authorisation and supervision framework for whole-life CDC schemes which applies for Royal Mail’s CDC vehicle. The government intends to extend this framework to CDCDAs, subject to a considerable level of modification reflecting the specific challenges they bring. Master trusts will be familiar with much of the structure already because it is adapted from standard master trust authorisation.
CDC in retirement is a notoriously complex area and it will be interesting to see the Department for Work and Pensions (DWP) policy develop. On a practical level, a central question for the industry is how to generate scale within a CDCDA: how to get a big enough pool of retirees in one place to enable CDC to work effectively from the outset. This might be hard to run in parallel with the very individualised world of ‘Freedom & Choice’ but CDCDAs may still probably happen at some stage – though it is very hard to predict when they will take off.
To enable all of this, the DWP is building a framework, but the CDCDA proposals are tentative. The DWP’s report reveals that the government still has not reached a decision on:
One key commitment in the report is on start-up costs. The government has indicated that CDCDA providers themselves should pay the start-up costs, rather than charging them to savers. In addition, providers should pay for any shortfall – at least in the short term – between running costs and administration charges, as well as the costs of dealing with any triggering events. This is likely to limit the market to those who are well resourced and in it for the seriously long haul.
The trickiest challenge to the government is the regulation of pricing. The response confirms that the Pensions Regulator (TPR) would scrutinise how CDCDAs are priced both at the outset, and on an ongoing basis. The DWP hopes to learn from the FCA’s approach to the pricing of annuities. This is a sensitive area as there is no hiding the potential threat CDCDAs could pose to the annuity market.
Savers may consider CDCDAs a cheaper option while not appreciating the difference between CDCDAs and annuities. Ultimately, there’s always going to be a premium to pay for the privilege of a guarantee.
For this reason, the response emphasises the importance of transparent communications to avoid the risk of overpromising or otherwise mis-selling CDCDAs. A CDCDA offering higher pension payments may be invested in high-performing assets which, however, carry an increased risk of pension payments being reduced if those assets fail to perform. This is a risk that does not arise under standard annuity products and that savers will need to understand.
And this links with a really interesting point on consumer protection. TPR is used to dealing with member protection, but for CDCDAs, it will need to attain a level of expertise in areas of pricing and competition that have previously more comfortably lain within the remit of the FCA. So, as well as the legislative framework TPR will need to develop its internal resource to cover the emerging and developing area of CDCDAs, at whatever point in time the industry is in a position to launch.
Master trusts could play a role by promoting their own CDCDA to their existing members. Allowing master trusts to act as default CDCDA providers could possibly help to build the scale required to make CDCDAs feasible. The question for the DWP is whether master trusts would be allowed to offer CDCDAs as a default, or whether CDCDA could only be used subject to each individual’s consent.
It is not safe to assume that CDCDAs would be appropriate for all DC savers. Indeed, some savers may instead prefer the flexibility offered by drawdown or the guaranteed payments provided by an annuity. Would those savers understand enough about their retirement options to opt out of a default CDCDA? The government acknowledges that it still needs to think through all the implications of using CDCDAs as a default. It could decide, instead, to require that regulated advice be provided to savers before they enter a CDCDA.
This is an important area to get right. One of the main advantages of whole-life CDC arrangements, in contrast with standard DC arrangements, is that they allow savers to receive an income in retirement without having to make any complex financial decisions about how to take their benefits. In some respects, this is an old issue brought back to life. After all, CDCDAs resemble with-profits products which many pension providers, including some master trust providers will be very familiar with.
Unless the government allows CDCDAs to be used as a default, savers will have a choice not just between income drawdown and a range of annuity products, with or without increases, with or without survivor’s benefits, but also a choice between different CDCDAs. Each offers very different outcomes, cost and risk. This carries risk around savers properly understanding what they are buying, and how they might react if the CDCDA they choose, or are defaulted into, underperforms.
Because of this, it is important that the regulatory framework helps manage the risk of delivery through occupational pension schemes – outside of the remit of the FCA – and also the risks previously identified in relation to with-profits. The DWP’s consultation response starkly accepts that CDCDAs would have access neither to the Pension Protection Fund nor the Financial Services Compensation Scheme. So, coming up with the right framework is no easy task, and the response has not yet tackled some of the central problems.
It appears clear that the government is committed to making CDCDAs work, and there is no reason to believe that a change of government would halt progress. The DWP intends to consult on draft regulations for whole-life commercial CDC schemes in the autumn of 2023, which will then lead to work on the legislative framework, with CDCDAs being progressed alongside this.
The DWP should follow up this consultation with an open discussion with the pensions industry on the best way to move forward with the implementation of CDCDAs. In particular, the discussion should explore how CDCDAs would fit in with members’ current DC options under ‘Freedom & Choice’ – particularly where CDCDA operates as a default. Furthermore, the DWP will need to decide how value for money should be assessed for CDCDAs, given the greater similarities to annuities than other pension arrangements.