How CDC Pensions can give better outcomes: an illustrative example

Jo is saving for a pension, and wants to have enough to provide for herself from retirement until death.

She intends to retire at 65 but, of course, does not know how long she will live for. She wants to be sure that she will have enough, even if she lives to be 100. That means she needs to save for 35 years of retirement. How can she do that?

Defined Contribution Pension plus drawdown

To do so, Jo will need to set aside £350 per month. The money will be invested in a way which seeks to give a balance of risk and return, and which aims to protect against inflation, etc.

When she retires she will drawdown an income each year, with the aim of making her savings last for 35 years. The income secured cannot be guaranteed, but her investment is designed to meet the cost of a decent living in retirement.

This approach is known as Defined Contribution (DC) plus drawdown. Of course if she dies before she is 100, there will be money left in her will.

Collective Defined Pensions

However, Jo also understands that her likely life expectancy, together with everyone else in her company is 85. That means that if they were able to save for a pension collectively, she and her colleagues would only have to save enough for 20 years.

As with any insurance, those who die young might be said to be ‘subsidising’ those who live to an old age. But everyone knows they will be provided for until the day they die. This reduces the cost a lot.

If saving for 35 years costs £350 per month, savings for 20 years might cost £200 a month. This approach is known as CDC. DC plus drawdown is thus 75 percent more costly than CDC, if the aim is an income in retirement and the money is invested in the same way.

Defined Contribution Pension plus annuity

The only other way Jo can get an income for life is to buy an annuity. An insurance company provides these.

To be sure that the payment is ‘certain’, the insurance company invests only in ‘safe’, low return securities. Once in retirement, these provide a very predictable income, albeit that annuities often do not offer protection against inflation. That is not a big concern today, but might well be in the future.

Equally problematic, the cost of an annuity varies with the cost of ‘safe’ securities, so before retirement, it is difficult for Jo to determine how much she will need to save. And annuities are expensive. As a result, Jo needs to set aside £270 a month, 35 percent higher than CDC. This approach is known as DC plus annuity.

Conclusion: CDC Pensions offer the cheapest way to ensure a decent living in retirement

In summary, if the cost of a decent living in retirement is £200 per month using CDC, it will be £275 per month for DC plus annuity, and £350 for DC plus drawdown. That is why, properly managed, CDC can offer a higher income in retirement for the same cost as other available pensions.

The results of this simplified example are consistent with all the studies conducted on CDC and reviewed in the RSA's response to the Government Consultation on CDC pensions.