Master trusts and CDC: time for UK schemes to plan ahead

The 2021 Pension Schemes Act (the Act) creates a new framework for CDC schemes and the draft regulations, issued by the DWP for consultation, flesh out that regime. Under the initial framework, CDC schemes will need to be single employer schemes, or schemes where all the employers are connected with one another. However, the DWP is expected to issue further regulations for consultation next year which will allow employers which are not connected to be in the same CDC scheme.

In a CDC scheme, investments and benefits are managed collectively. While they offer no guarantees, this should lead to overall better results for members. However, even large companies may be put off by the cost of setting up such a scheme. For these employers, joining a scheme set up by an experienced commercial provider – a master trust – once regulations allow could be an attractive option.

What is a CDC scheme?

CDC schemes are a halfway house between defined benefit (DB) schemes, which promise employees a guaranteed pension on retirement, and defined contribution (DC) schemes, under which benefits depend on investment performance of the pot that members and employers have paid into.

Like traditional DC schemes, CDC schemes provide no guarantees. Instead, they target a DB-style benefit. Employers make fixed contributions to the scheme with no further liability, other than in relation to expenses. Members are informed of their target income on retirement. If scheme assets prove insufficient to pay the target pensions for members, lower pension increases could be targeted or a lower level of overall target could be set. Even pensions in payment could be reduced if there is a deficit.

All CDC scheme assets are invested collectively. There are no individual pots, so members are not faced with the challenge of investment options. When members retire they are paid a pension from scheme assets. Mortality risk is therefore spread among members rather than borne by each individual member, as under a traditional DC scheme. Members can choose to transfer out if they would prefer to buy their own annuity or draw down on their own individual pot.

Why might an employer choose a CDC scheme?

CDC schemes have a number of inherent advantages. Like DC schemes, contributions are fixed and there are no unexpected deficits to plug. Investment and longevity risks are shared between members through collective investment. This means that, as with DB schemes, assets can remain invested in higher return assets over members’ lifetimes. CDC schemes can take a longer-term view and invest more of their assets in illiquid investments such as infrastructure and patient capital – something which tends to be more problematic for standard DC schemes.

On retirement, members receive an income stream without having to work out for themselves whether to buy an annuity or having to calculate how much income they can safety draw down from their pot. Many employees prefer the fact that CDC schemes only offer limited options in relation to contributions and benefits. The risk of members making inappropriate choices is reduced.

Pension provision is a long-term undertaking. Some employers are starting to consider now whether an innovative CDC scheme could be just right for their workforce.

Why should master trusts be thinking about CDC benefits?

The government’s policy is to open up the CDC regime to commercial master trust providers once any potential teething problems with the new regime have been ironed out. Issues could arise from confusing member communications; inappropriate actuarial assumptions; complex administration; and problems with the implementation of the modified pensions taxation regime.

Master trusts potentially offer a number of advantages in comparison with schemes set up for a single corporate group. CDC schemes work best when mortality risk is pooled across as large a population as possible, and when that population includes members of all ages – indeed, mortality pooling is the main selling point of a CDC scheme over a traditional DC scheme. Master trusts are able to provide a mass market product covering far larger populations than schemes set up just for a single corporate group.

If we add to the mortality pooling all the other advantages of master trusts, the case is compelling. Master trusts already have experience of complying with an authorisation and supervision regime run by the Pensions Regulator. They already have effective governance systems and investment, communication and administration expertise. Master trusts just need to add the required actuarial expertise to their armoury in order to offer CDC.

Although it will be some time before master trusts will be able to set up their own scheme, now is the time to consider the possibilities. In the short to medium term, master trusts are probably more likely to consider CDC as another decumulation strand rather than more generally as an alternative form of accumulation.

Undoubtedly CDC will bring complications for master trust providers to work through and it is not yet clear how quickly the market will move, but the government is putting a lot of time and effort into drafting legislation to enable CDC schemes. In addition, the Pensions Regulator will be devoting considerable resources to establishing a sound authorisation and supervision regime. These efforts demonstrate the government’s belief that CDC schemes have the potential to take off and become a significant part of the pensions landscape.

There are also likely to be commercial advantages of offering CDC. Since CDC schemes offer an all-encompassing, streamlined savings and income payments package, members will be less tempted to transfer out of a CDC scheme on retirement. CDC schemes certainly offer new business opportunities. Master trusts need to consider what is changing and review their own strategy – which may well include CDC.