A look at how collective defined contribution schemes differ from DB and DC schemes and why SA’s pension industry should note the shift in the UK.

The local pension industry seems poised to embrace the collective defined contribution (CDC) model in the future despite their complexities.

New administration systems to accommodate these types of structures will have to be designed as well as new regulations to govern them. An employer and member education drive to explain how these schemes operate will also be needed.

I for one am excited to see South Africa’s pension industry having these types of conversations and looking for new ways to improve member outcomes at retirement.

Having spent the last 12 months as head of defined contribution (DC) investments at a large pension consultancy in London, I was surprised at the striking similarities between the South African and UK pension industries.

The UK industry is experiencing a shift to CDC schemes and SA should take note of how these schemes work.

From defined benefit to defined contribution and CDC
In South Africa, DC pension schemes have been the default for many years.

DC schemes provide members with a pot of money they can use in retirement, the value of which can rise or fall depending on investment returns and contributions made, among other factors. These schemes do not provide a guaranteed pension.

The biggest pension scheme in SA, and Africa for that matter, however, the Government Employees Pension Fund (GEPF), remains a defined benefit (DB) fund.

A defined benefit fund pays a promised pension, which is based on factors such as salary and length of service. A sponsor, usually an employer, guarantees the promised benefits are paid. The pension provides an income for life and may also include a retirement lump sum.

The latter had been the standard in the UK until DC schemes slowly grew in popularity. The split between DB and DC in the UK, for many years, was 80/20 but this is now changing as more DB funds move to buy-in/buy-out structures and DC becomes the new default. This is a global trend.

Most private sector DB schemes are now closed. The proportion of private sector employees participating in a defined benefit pension halved from 24% in 2005 to 12% in 2020. They continue to operate in the public sector.

Collective defined contribution
Collective defined contribution (CDC), also known as a target benefit or defined ambition plan, is a type of retirement savings plan where contributions are pooled together and invested to provide members with an income during retirement.

Unlike a traditional (DC) plan where individual members choose their own portfolios and bear their own investment risk, a CDC plan spreads the investment risk among all members. This risk pooling means individual investment and longevity risk is significantly reduced, offering more certainty.

The primary goal of a CDC plan is to provide a target or ‘ambition’ income in retirement, rather than a guaranteed amount. CDC plans aim to provide a consistent income during retirement, providing members with an income stream that many find easier to manage than a lump sum.

The income a member ultimately receives is dependent on several factors, including the performance of the investments and the longevity of members within the fund.

Both the employer and employee contribute to a collective fund. As employer and employee contributions are fixed, these schemes provide cost certainty.

The collective nature of CDC offers a wider range of investment opportunities with a longer-term investment horizon. This enables the scheme to invest in long-term assets like private markets, which may lead to potentially higher returns than in individual investing.

Read the complete article here