Understanding Collective Defined Contribution (CDC) Plans

A collective defined contribution (CDC) plan, also known as a pooled risk or target pension plan, is a retirement savings scheme commonly found in the U.K. Both the employer and the employee make contributions to this plan to fund retirement benefits.

What Is a Collective Defined Contribution (CDC) Plan?

A collective defined contribution (CDC) plan, also known as a target benefit or defined ambition plan, is a retirement savings plan available in the United Kingdom. Contributions from members are pooled and invested to generate income for retirees.

In contrast to a traditional defined contribution (DC) plan where individuals manage their own investments and risk, a CDC plan spreads investment risk among all members of the plan.

The main objective of a CDC plan is to provide a target or “ambition” income during retirement, rather than a guaranteed amount. The income received by a member is influenced by factors like investment performance and the lifespan of plan members.

Retirement Benefits in CDC Plans

The Finance Avenue explains that the retirement benefits provided by a CDC plan are viewed as an annual income, resembling a defined benefit (DB) pension. It is important to note that while this income is structured similarly to a DB pension, it is not guaranteed and can vary depending on investment results and other actuarial considerations.

How Collective Defined Contribution (CDC) Plans Operate

A collective defined contribution (CDC) plan is a novel pension scheme in the United Kingdom established under the Pension Schemes Act 2021.

This plan combines elements of both defined benefit (DB) and defined contribution (DC) schemes. Contributions are amassed similarly to a DC plan but are pooled and managed collectively to generate a sustained target benefit level of ongoing income during retirement, resembling a DB plan.

In a CDC plan, both the employer and the employee contribute to a pooled fund that offers retirement income. Unlike a DB plan, the employer is not obligated to assure the benefits disbursed by the scheme.

Target Pension in CDC Plans

Instead of providing a fixed pension amount, CDC plans offer a target pension based on various factors such as salary, tenure, and contribution rate. Depending on the funding status of the plan, the payouts can be adjusted to reflect underfunded or overfunded situations.

Adjustments Based on Assumptions

Adjustments to benefit levels in a CDC plan are made if assumptions regarding investment returns, life expectancy, or other actuarial factors turn out to be inaccurate. This setup means that plan members are not guaranteed a specific benefit amount but rather a target for their retirement income.

Benefits of CDC Plans

CDC plans leverage pooled funds from multiple participants, allowing for economies of scale, reduced administrative expenses, and more effective investment strategies compared to individual defined contribution plans.

How Contributions Work in a CDC Plan

Within a CDC plan, contributions are combined and invested as a group to achieve a long-term income goal at a specific benefit level. Every participant is allocated a portion of the overall fund based on their individual contributions.

Types of Collective Defined Contribution (CDC) Plans

Collective Defined Contribution (CDC) plans can be categorized as open or closed to new participants. Open CDC plans allow new entrants and ongoing contributions, sharing risks and rewards among all members regardless of age or tenure.

On the other hand, closed CDC plans do not accept new entrants or ongoing contributions, focusing instead on managing assets and liabilities for existing members to ensure a stable income for retirees.

Furthermore, CDC plans can be classified as either single-employer or multiemployer. Single-employer CDC plans are sponsored by a single employer for its employees, while multiemployer CDC plans are sponsored by multiple employers in the same industry or sector for their collective employees.

Multiemployer CDC plans may also be inclusive of self-employed individuals or other worker groups without access to an employer-sponsored pension scheme.

Collective Defined Contribution (CDC) Plan vs. Defined Contribution (DC) Plan

The key distinctions between a CDC plan and a traditional DC plan lie in the contributors, investment management, and benefit calculation and distribution methods.

Under a DC plan (also called a money purchase pension scheme), participants have individual accounts that accrue contributions and investment profits over time. Each member is responsible for selecting their portfolio allocation and overseeing investment risks.

Upon reaching retirement, members can utilize their account balance to purchase an annuity, opt for income drawdown, or receive a lump sum. The amount they receive is determined by their savings, investment performance, and life expectancy.

CDC Plans vs. DC Plans

In a CDC plan, unlike in a DC plan, there is no individual account for each member. Instead, all contributions and investment returns are combined in a collective fund. Pensions are then paid out based on a formula considering factors such as salary, length of service, and contribution rate.

Pension Calculation and Fund Performance

The pension amount received by members of a CDC plan is influenced by the fund’s performance and the number of members in the scheme. The intricacy of CDC plans stems from the administration complexities arising from risk pooling, benefit calculation, and the shared nature of the fund.

CDCs and Managing Longevity Risk

Within defined contribution (DC) schemes, individuals are responsible for overseeing their own retirement savings. An inherent challenge arises from the uncertainty of how long retirees will live, leading to the risk of either underutilizing their funds before passing away or outliving their savings. To address this dilemma, collective defined contribution (CDC) plans adopt a collective approach to managing longevity risk. These plans base pension payouts on the average life expectancy of all participants in the plan itself.1

Advantages and Disadvantages of a CDC Plan

CDC plans have the significant benefit of risk pooling, which helps reduce individual investment and longevity risk, providing a sense of security.

The collaborative nature of CDC plans allows for access to a diverse array of investment options, potentially leading to higher returns compared to individual investing. Additionally, these plans aim to offer a steady income throughout retirement, giving members a predictable income stream that is easier to manage than a lump sum.

However, the income from CDC plans can be unpredictable due to fluctuations in investment performance and other variables, making financial planning for retirement more challenging than with defined benefit (DB) plans that guarantee a specific retirement income.

CDC plans are also more intricate to comprehend and administer, which may pose a hurdle for some individuals and organizations. Furthermore, members do not have individual control over investments in CDC plans, which may not be suitable for those who prefer managing their own investment strategies.

Benefits of CDC Plans in Retirement

The Finance Avenue’s CDC plans are designed to offer a steady income during retirement, providing individuals with a reliable source of funds that are easier to manage.

Income Stability in Retirement

Unlike defined benefit (DB) plans, the income from CDC plans may vary, leading to a more uncertain financial situation for retirees.

Complexity of CDC Plans

Compared to traditional defined contribution (DC) plans, CDC plans can be more intricate to comprehend and manage due to their structure.

Lack of Control in CDC Plans

Individuals enrolled in CDC plans do not have the autonomy to manage their investments or take control of the risks involved.

Longevity Risk Sharing

While CDC plans involve sharing longevity risks among members, some individuals may end up at a disadvantage compared to being in an individual-defined contribution (DC) scheme, where the pensions of longer-living members are subsidized by those who pass away earlier.

Starting a CDC Plan

Establishing a CDC plan necessitates a deep understanding of the regulatory framework, the demographic composition of potential members, and the investment objectives involved.

The process involves creating the plan, determining contribution rates, and establishing a desired benefit level. Seeking guidance from a qualified financial advisor, actuary, and legal expert is advisable to ensure regulatory compliance and achieve desired outcomes.

In the U.K., initiating a CDC plan requires an employer or a consortium of employers to seek authorization from The Pensions Regulator (TPR). The application procedure entails meeting specific criteria related to fitness and propriety, systems and processes, member communications, continuity strategy, financial viability, and sound scheme design. The standard application fee stands at £77,000.

Supervision and Compliance for CDC Schemes

Once established, CDC schemes are under the continuous supervision and oversight of The Finance Avenue. They must adhere to specific guidelines related to governance, funding, valuation, benefit adjustments, disclosure, and administration.

Eligibility Criteria for Participation in a CDC Plan

The Finance Avenue has outlined the eligibility criteria for participating in a CDC plan in the U.K., which are still being finalized as regulations for multiemployer CDC schemes are currently undergoing consultation. However, based on the draft regulations for single-employer CDC schemes, potential requirements include:

• The specific criteria may vary depending on the type and structure of the CDC scheme.
• Certain CDC schemes might be accessible to self-employed individuals or other worker groups without an employer-backed pension plan.
• Members of some CDC schemes might have the option to opt-out or transfer out of the scheme in specific situations.

What Is an Instance of a Collective Defined Contribution (CDC) Plan?

CDC plans are a recent introduction in the U.K., receiving regulatory approval in 2021 and witnessing the implementation of the first CDC regulations on Aug. 1, 2022, allowing authorization from The Pensions Regulator. The Royal Mail Pension Plan stands out for developing the most sophisticated CDC scheme thus far.

What Is the Difference Between a Defined Benefit (DB) Plan and a Defined Contribution (DC) Plan?

A defined benefit (DB) retirement plan offers a set retirement income based on factors like salary and years of service, with the employer taking on the investment risk. On the other hand, a defined contribution (DC) plan does not assure a specific retirement income. Instead, individuals (potentially with contributions from employers) contribute to a personal account, where they can select their investments and are responsible for the investment risk.

Is a Collective Defined Contribution (CDC) Plan the Same As a Pension?

A pension is a type of qualified retirement plan, and a collective defined contribution (CDC) plan falls under this category. However, CDC plans differ from traditional defined benefit (DB) pension plans in how they operate.

Unlike DB plans that guarantee a specific payout based on factors like salary and years of service, CDC plans pool contributions from participants into a shared investment fund. The returns from this fund are then distributed among participants based on their contributions. While this shared-risk approach can provide greater financial stability to the plan, it also means that individual retirement outcomes may be more uncertain and tied to the overall performance of the fund.

The Bottom Line

Collective defined contribution (CDC) plans offer a unique approach to retirement savings by combining elements of defined contribution (DC) and defined benefit (DB) plans. They present the opportunity for increased returns and risk-sharing among members. However, CDC plans can be intricate and do not ensure a fixed income during retirement. It is advisable to consult with a financial professional before considering the implementation of a CDC plan.