Having just joined Irwin Mitchell last week, this is my first opportunity to write an article. As it happens, the government has just released plans to launch a new type of pension, so this gives me a great subject on which to research and report back.
Collective Defined Contribution schemes (CDCs) are being touted as a game changer, but it may not be immediately apparent what has changed.
In order to contextualise this correctly, it’s important to consider the two current types of pension, at which point we can explore where the new type fits in. At present, schemes are either defined benefit or defined contribution schemes, with a number of different sub-varieties for each.
Defined benefit schemes are, as the name implies, a promise by a pension scheme to pay a certain level of income and lump sum in retirement. The basis for accruing benefits varies enormously, but generally it is based on length of service and salary either at retirement or over the course of the whole employment.
Generally such schemes are funded from employers, with a small proportion of the overall cost of providing the pension levied against the scheme members themselves. Very briefly, the requirement to fund the scheme is entirely applied to the employer, who must make up any shortfalls in funding if the scheme’s investments fail to perform as required to fund the promised incomes.
On the other hand, defined contribution schemes flip the funding and growth burden entirely. Instead of promising an income and lump sum in retirement, an employer offering a defined contribution scheme simply pays a one-time amount each payroll cycle, after which they no longer have any responsibility for how the pension performs. Members of such schemes are expected to make their own investment decisions to try to maximise their retirement pots.
The difference between these two types of scheme is enormous. In the case of defined benefit schemes, the member can fully plan their retirement, knowing exactly what they are entitled to and from what date. The trade-off is that such schemes tend to be fairly inflexible and may offer poor death benefits. With defined contribution schemes, there is much more flexibility, in that the member can invest howsoever they wish (within regulation), but the investments must be managed correctly for that specific investor, including their time horizons.
At this time, there is a proposed solution, namely the Collective Defined Contribution (CDC) scheme. This would retain the simplicity of contributions, with both employer and member able to make one-off contributions that do not bind either party to any future liabilities; however the new type of scheme will be run as a pooled investment. This means that the investment manager can make longer-term investments where they see value, even if some of the members have a relatively short-term investment horizon.
It’s early days, but it’s interesting to see mainstream pension schemes gaining this pooled investment approach, something that has previously been limited to small schemes. Clearly the devil will be in the details, but the early indications are certainly promising.
If you would like to know more about how your pensions are structured and how we can help please get in touch for an initial chat. Ian Hawkes - Financial Planner | Asset and Wealth Management Irwin Mitchell