Retirement plans get new approach

Collective defined contribution (CDC) is a hot topic in the industry, with many supporters, including the Minister for Pensions, Torsten Bell, highlighting its potential for superior member outcomes. However, there are also skeptics who argue that CDC is just a complex financial concept.

A useful way to think about CDC is to imagine a gardener who plants a single fruit tree, representing individual pension savings. The tree is watered regularly, and after many years, it grows and starts to produce fruit – the reward for all that effort.

Understanding the Risks

Being reliant on just one tree comes with risks, such as the tree not growing well or suffering from disease, resulting in too little fruit. This is similar to the challenges of a typical defined contribution (DC) pension, where individuals are responsible for their own investment decisions and bear the investment risk.

In a DC pension, individuals must decide how ambitious or cautious to be, particularly near or in retirement, and manage the risk of outliving their savings. This can be an uncertain path, making it difficult for individuals to ensure a steady income in retirement.

The Orchard Approach

Alternatively, imagine joining a gardening club, where a sapling is planted, but instead of having your own tree, you get a share of the entire orchard. Everyone contributes by watering the trees, and in return, the club aims to give you a steady supply of fruit from a set date for the rest of your life.

Related: Pension funds see impact from stewardship efforts

This approach has clear advantages, as you are not dependent on a single tree – if one tree has a bad year, others in the orchard can make up for it. The orchard can also take more risks overall, including using powerful fertilizers, without putting the whole orchard at risk.

Critically, the amount of fruit distributed to each member is based on how long the average member is expected to live. This means that retired members know they can keep getting fruit for life, even if they live longer than expected.

Trade-Offs and Benefits

However, there are trade-offs to the orchard approach. If the tree you planted produces a bumper crop, you need to share the windfall across the group. And if you pass away before the tree, you cannot leave behind a tree that your family can inherit.

CDC does not eliminate risk, but it does redistribute it. By joining a collective scheme, members can share the risks and rewards of investment, potentially leading to more predictable and sustainable outcomes in retirement.

According to the report, CDC schemes share longevity risk, which ensures an income for life, but in the event of an early death, the residual capital is not passed to your estate.

Related: Men use job offers to get raises

CDC is not a magic solution, but rather a different approach to managing retirement risks. By understanding the benefits and trade-offs, individuals can make more informed decisions about their retirement planning.

The orchard metaphor highlights the differing features of a CDC, with only one shared investment fund, so risk is shared across members and spread over time. This means that a CDC can take on more risk than a typical DC, but any windfall return is shared by all.

It is likely that CDC will play a larger role in retirement planning as the industry continues to evolve. With its potential for superior member outcomes and more predictable income streams, CDC is definitely worth exploring further.

Individuals can visit the Wikipedia page on CDC plans or consult with a financial advisor for more information on collective defined contribution.