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How would recent market falls have affected members approaching retirement in a CDC scheme?

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By Simon Eagle , Anne Swift and Henry Parker | May 12, 2020

The impact COVID-19 has had on the global equity market has left members of defined contribution plans near retirement with uncertainty and difficult judgements to make. But how would this have differed if they were in a CDC scheme?

Collective Defined Contribution (CDC) is expected to be a new way to provide pensions in the UK from 2021, once the Pension Schemes Bill 2019/20 has achieved Royal Assent and the associated legislation is in place.

One of the aims of CDC is to smooth out the volatility in at-retirement pension levels seen in individual DC. This is done by sharing risk collectively between members and gradually varying benefit levels in reaction to market movements.

This way, benefits can be paid as relatively stable pensions, giving members greater certainty with which to plan for retirement relative to individual DC particularly during times of market volatility, but still be funded by contribution levels which are fixed in advance.

The first quarter of 2020, which saw the global equity market suffer a severe fall of around 20% in reaction to the Coronavirus pandemic, demonstrates this attractive feature of CDC as we explore in this blog post.

How would a CDC scheme have coped with the market falls?

As an example we’ve looked at the effect on CDC pensions under the design published by Royal Mail. We’ve looked at someone close to retirement who, in this scenario, would be able to retire as planned with no reduction to their retirement income.

Why is this case? Well, the Royal Mail CDC scheme design determines benefits as annual pension amounts based on career average pay, where the pension increase levels - both before and after retirement - vary each year in reaction to changes in the funding health of the scheme. Contribution rates are fixed in advance.

When the scheme is opened, there is a certain amount of ‘headroom’ in the contributions, designed to fund for future pension increases; it is only if the funding health suffers very materially that the headroom could run out and pensions would be reduced.

Based on Royal Mail’s scheme design, the initial headroom is over half of the contributions and is expected to provide for average long-term increases of 1% pa above CPI. It would therefore take a far more significant fall in markets for a member’s pension to fall; in the vast majority of scenarios, it would only be the level of future pension increases that would be at risk.

Under this design the Q1 market shock therefore has no effect on current pension levels for the CDC members – whether this is a current pensioner, or someone due to retire in the next few years. Instead it affects the next pension increase, and future pension increase expectations.

Based on the Royal Mail’s intended diversified return-seeking asset portfolio, we estimate that the collective assets would have fallen by around 7%. This reduces the ‘headroom’ funding for future increases but is nowhere near severe enough to remove it. In isolation this asset fall would have reduced future CDC pension increase levels by around 0.25% a year.

So, for a CDC member about to retire, there would have been little effect on their initial retirement income, but potentially a modest reduction in long-term future pension increases depending on how markets develop. As intended, Q1 market falls would have been smoothed out and the member could retire as planned without the need to face a difficult retirement decision.

How does this compare to individuals in DC plans?

The effect on each individual DC member depends on the timing of their retirement, their investment strategy, and how they plan to take their retirement savings.

For members many years from retirement, while the market movements might be disconcerting and had a significant impact on their pension pot, we expect the majority to make no changes to their retirement arrangements and wait and see how things develop until they are closer to retirement.

For a member due to retire in the near future with a typical drawdown investment strategy, we expect their pension pot to have fallen by c. 10% over the quarter. While this member could still choose to retire as planned without locking in this loss, as their pension pot will largely remain invested, the market falls will have introduced significant uncertainty for the member. This may require a rethink of retirement plans, for example changing their planned pace of drawdown or deferring retirement.

A member looking to buy an annuity will however typically invest in assets with less exposure to equity markets and have some bond holdings once they are close to retirement, so overall their pot will typically have remained broadly flat. However, prices for level annuities have become around 8% more expensive over the quarter due to falling bond yields.

This member is therefore left with a conundrum - go ahead and retire now on a pension which is around 8% less due to unlucky timing or, if he or she has the option through alternative income, defer retirement in the hope that markets and annuity prices eventually combine to provide a higher income.

In both cases, the market fall has therefore led to uncertainty and difficult judgements for the individual DC member near retirement. The CDC member on the other hand has been able retire on the income they expected, with a modest potential reduction in future pension increases.

Contacts

Simon Eagle
GB Head of CDC Consulting

Anne Swift
Senior Director, Investments

Henry Parker
Associate Director, Investments

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