Decumulation-only collective defined contribution (CDC) pensions could offer new opportunities in the retirement income market and to retirees, but faces challenges in being successful, according to a new report from the Pensions Policy Institute (PPI).

It noted that decumulation-only CDC schemes should be able to fulfil their objectives while operating under the current design constraints.

CDC schemes were introduced in the Pension Schemes Act 2021 and the PPI believed the legislation was flexible enough to support other applications for CDC schemes.

However, it warned that maintaining the aim of greater transparency and fairness in the UK would lead to challenges for decumulation-only CDC, as they will need to operate without smoothing mechanisms, such as buffers, and with a more limited time horizon of future liabilities than whole-life CDC implementations.

Decumulation CDC can offer a higher degree of investment in growth assets than an annuity, the PPI noted, and can therefore provide a higher, but slightly more volatile, income for life than an annuity, without the risk of fund exhaustion associated with drawdown.

The report stated that the majority of risk and volatility issues in decumulation CDC stem from investment performance, and schemes will need to consider the balance of higher opening benefit levels and the degree of predictability of future benefit levels that can be provided.

Within fairness considerations, it would be “imperative” that the sharing of longevity risk was fair, which will require consistent underwriting, with personal longevity risk needing to be consistent with the aggregate longevity risk within the scheme.

The PPI added that insufficient scale was more of a threat to the economic viability of a decumulation CDC scheme than to its effective risk pooling, and the necessary scale may be equivalent to that required for a master trust for the scheme have an adequate charging base to cover its costs.

Decumulation CDC will need to interact with other decumulation options, both as competition and to compliment, to prove successful amid the range of other products, according to the PPI.

However, the “single biggest challenge” facing decumulation-only CDC was communication.

It stated that experience from the Netherlands, where communication with CDC scheme members failed to align expectations with reality, resulted in a loss of trust in their pension system.

The PPI also warned that introducing decumulation CDC to the UK pensions market would make a complicated decision more complex, and a personalised mix of decumulation products may ensure the best outcomes for members.

“Decumulation-only CDC would allow a retiree to buy a product that gave them an income for life, removing the risk of spending their money too quickly or too slowly,” commented PPI policy analyst and report author, John Upton.

“It could also differentiate itself by offering more risk and reward than other income-for-life products currently on the market. The downside would be that this investment risk translates into less predictable benefit changes year on year.

“For providers, they must first decide on the scheme’s objectives, and then communicate this to members so that they can properly understand what they are signing up for. To explore these issues, the PPI constructed models to explore how this could play out in a wide range of circumstances.

“The modelling results showed that decumulation CDC, investing more aggressively than an annuity would, would generate a larger benefit for members on average. However, because of the way a CDC scheme is currently anticipated to be legislated, the change in benefit that a member would see each year would be sensitive to investment performance, making it less attractive to savers who may not have capacity for this uncertainty.

“The results suggest that chief among a decumulation-only CDC scheme’s considerations would be the investment strategy, allowing both the possibility of delivering attractive benefit levels, and the risk of not meeting member expectations of an income-for-life product.

“There does appear to be a home for decumulation-only CDC in the retirement product space, perhaps by complementing other products rather than competing with them. For someone who already has a suitable underpin from another source, decumulation CDC may offer a way to make their DC pot go further, without having to make complex decisions regarding longevity or investment whilst accepting greater uncertainty.”

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