After Years of Planning, UK Finally Authorizes First CDC Pension Plan

Five years after being proposed and more than two years since being introduced by the Pension Schemes Act 2021, the Royal Mail Collective Pension Plan has become the first collective defined contribution pension plan authorized in the U.K.

Collective defined contribution plans offer a third type of pension plan, in addition to defined benefit plans and defined contribution plans. In a CDC plan, both the employer and employee contribute to a collective fund that provides an income in retirement. Unlike a defined benefit plan, the employer does not guarantee the benefits paid by the plan. Instead, CDC plans provide a target pension; if the plan is underfunded or overfunded, the pensions it pays can be decreased or increased accordingly.

The Pension Schemes Act of 2015 first included a provision for the government to allow the creation of CDCs, which were then called defined ambition pension plans. However, the provisions never came into force. In February 2018, after the Royal Mail decided to close its defined benefit plan, the postal service company and the Communication Workers Union agreed to introduce a CDC plan. Regulation at the time, however, did not permit CDCs.

The following month, the U.K. government noted that there had been calls for it to legislate a provision for CDC plans. Later that year, the government concluded that the provisions in the Pension Schemes Act of 2015 Act were not the most appropriate way of providing CDC benefits.

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The Pension Schemes Act of 2021 eventually provided the necessary legislation, and CDC regulations came into force in August 2022 allowing plans to apply for authorization from The Pensions Regulator.

“TPR authorizing the first CDC scheme is a landmark moment, and this is just the beginning,” Laura Trott, the U.K.’s minister for pensions, said in a release. “We have seen the positive effect of these schemes in other countries, and our plans to extend our CDC framework will enable more pensioner savers to achieve the retirements they want.”

While CDC plans are new to the U.K., they are common in the Netherlands, Canada and Denmark, yet not everyone is convinced CDC plans should be adopted. A report from the Centre for Policy Studies, a conservative think tank, called CDCs risky and untested.

“The system risks creating irreversible intergenerational injustice by overpaying pensioners at the expense of current and future employees,” the report said. “The evidence all points to an obvious conclusion—CDC schemes in the UK are superfluous.”

Unison, the largest union in the U.K., urged caution when the U.K.’s Department for Work and Pensions announced it was launching the new pension model. Defined benefit plans remain Unison’s preferred type of pension plan for its members, although it does see CDCs as an improvement over defined contribution plans.

“UNISON supports improving member outcomes through the introduction of collective defined contribution for members in defined contribution schemes,” Glyn Jenkins, Unison’s head of pensions, said in a release. “But the new schemes should not be used to replace viable defined benefit schemes.” Jenkins added that “these new pension arrangements must not erode current provision.”

Corporations Contributing Less

As more pension funds continue to reach fully funded status, recent trends indicate that U.S. corporations are lowering their planned contributions.

According to Brian Donohue, a Chicago-based partner in October Three Consulting, contributions have been trending down among 212 Fortune 500 employers that sponsor pension plans, to $13 billion in 2022 from $48 billion in 2018.

Donohue said this trend is expected to continue in 2023, with companies disclosing intended contributions this year of just $3 billion.

Funding ratios improved significantly in 2022 because of rising discount rates, which caused corporations to not have to make minimum required contributions for their plans. This is positive news for many corporations, as it is possible that companies might not have to make contributions again.

Equity Markets Rally

LGIM America’s April Pension Solutions Monitor showed that the average funding ratio is estimated to have increased to 100.5% from 100.3%.

Equity markets rallied through the month, according to LGIM, with global equities and the S&P 500 increasing 1.5% and 1.6%, respectively. Plan discount rates were also estimated to have decreased roughly 5 basis points over the month, with the Treasury component decreasing 3 bps and the credit component decreasing 2 bps.

In addition, LGIM found that plan assets with a 50%/50% bond/stock asset allocation increased 1.1% while liabilities increased by 0.9%, resulting in slight improvement in funding ratios by April month-end.

Overall, LGIM concluded that the combination of stronger asset performance and rising liability values kept funding ratios relatively unchanged throughout the month.

October Three found similar results, as the firm said pension plans have “managed to hang on to the significant improvement in funded status over the past two years.” Even though interest rates have drifted lower this year, positive stock markets have allowed plan sponsors to keep pace so far, October Three’s report stated.

The firm also found that bonds gained about 1% last month. For the year through April, a diversified bond portfolio earned 4% to 7%, with long-duration bonds performing best.

Corporate bond yields fell 5 bps in April, and as a result, pension liabilities rose 1% during the month and are now up 5% to 7% for the year through April, October Three found.

The WTW Pension Index also saw an increase in April as a result of positive investment returns, partially offset by an increase in liabilities due to a small decrease in discount rates. Overall, WTW’s index level of 100.8% reflects an increase of 0.2 percentage points for the month.

WTW tracks the performance of a hypothetical pension plan invested in a 60% equity/40% fixed income portfolio, which received a 1% return for the month. In addition, the liability implicit in the index increased by 0.8% from the discount rate change and the accumulation of interest.

Mixed Global Equity Market Returns

Agilis’s Pension Briefing reported that funded statuses improved slightly for plans with significant allocations to large cap developed market equities, but plans with more significant allocations to emerging market stocks or small caps could have seen funding levels decrease.

The Treasury yield curve leveled out slightly in April, with very short-term interest rates increasing and long-term bond yields decreasing, while credit spreads narrowed as stresses in the market eased. These changes were positive for bond market returns but resulted in a slight decline in discount rates which increased liabilities, according to Agilis.

Meanwhile, global equity market returns were mixed, according to Agilis, as large-cap developed markets had positive returns, and emerging markets, as well as mid- and small-cap stocks, reported negative returns. The fixed-income markets were generally positive.

“With the Fed raising the Fed Funds Rate for the 10th time in a row in early May, the markets are now expecting them to hold steady and potentially start cutting the rate later this year, even though the Fed is saying they are most likely to hold steady,” said Michael Clark, managing director at Agilis. “With another strong jobs report, a lot will depend on what happens with inflation and any potential negative economic event that may play out (e.g. debt ceiling debates, geopolitical escalation). As we’ve said before, pension plan sponsors will continue to deal with uncertainty and volatility in 2023.”

On the positive side, Agilis found that volatility decreased in April, thanks to easing worries about regional banks and better-than-expected first-quarter earnings. The job market also remained strong, as U.S. companies added 296,000 jobs in April, up from 142,000 in March, although initial jobless claims rose modestly.

Because the Fed raised interest rates again in May, Agilis’s report said there is little agreement about what the rest of the year will hold.

“Meanwhile, the U.S. House of Representatives passed a debt-ceiling bill in an effort to avoid a government shutdown, but the bill moves to the Senate, where passage will be more difficult,” the report states. “With this political uncertainty on the horizon, we anticipate more market volatility that will cause pension funded status to fluctuate as well.”

Some Say Funded Status Deteriorated

Aon’s Pension Risk Tracker found that while the aggregate funded ratio for pension plans in the S&P 500 increased to 98.3% from 98.2% in the first quarter of 2023, the S&P 500 aggregate pension funded status decreased slightly during the month of April, to 98.3% from 98.5%

Pension asset returns, however, were up slightly throughout April, according to Aon, ending the month with a 0.8% return.

The pension funding deficit has decreased by $1 billion so far this year, and Aon said this has been driven by assets growing $51 billion, offset by a liability increase of $50 billion year-to-date.

Aon also found that the month-end 10-year Treasury rate decreased 4 bps relative to the March month-end rate, and credit spreads remained constant.

“This combination resulted in a decrease in the interest rates used to value pension liabilities from 4.89% to 4.85%,” Aon’s report stated. “Given a majority of the plans in the U.S. are still exposed to interest rate risk, the increase in pension liability caused by decreasing interest rates offset the positive effect of asset returns on the funded status of the plan.”

Despite investment gains in April, Milliman’s Pension Funding Index reported that funding of the nation’s 100 largest corporate pension plans decreased by $7 billion during April. A decrease in interest rates used to value pension liabilities also resulted in an increase in liabilities of $10 billion for the month, Milliman fund.

As of April 30, Milliman said the funded ratio fell to 99.5% from 100.1% at the end of March.

Looking ahead, if the Milliman 100 PFI companies were to achieve an expected 5.8% average investment return, and if the current discount rate of 4.92% were maintained during 2023 and 2024, Milliman forecasts that the funded status of the surveyed plans would increase.

Related Stories:

Corporate Pension Funding Ratios See Slight Increase in February

Corporate Pension Funding Posts Small Gain in January

Poor December Equity Performance Reduces Pension Funding Status

Tags: Agilis, Aon, Insight Investment, Legal & General Retirement America (LGIMA), Michael Clark, Milliman, October Three Consulting, Pension Funding Status, Pensions, Wilshire, WTW