An Introduction to Collective Defined Contribution Plans
By Mark Shemtob
Retirement Section News, July 2023
If you’re new to collective defined contribution plans the following will provide useful information.
1. What are collective defined contribution (CDC) plans?
CDC plans are essentially defined contribution (DC) plans with the added feature that they are designed to pay out benefits in the form of a lifetime income similar to a traditional defined benefit (DB) plan.
2. How is a CDC plan different from a traditional DB Plan?
Unlike the steady income level of a traditional DB plan, the CDC pension income level varies based on the performance of the plan trust investments and the mortality experience of the plan participants. The traditional CDC design does not allow for the employer or plan sponsor to assume any liabilities for benefit underfunding; the plan participants bear the risk of any underfunding. A design with no employer unfunded liabilities would eliminate Pension Benefit Guaranty Corporation premiums (if applicable) and corporate balance sheet liabilities, which have caused many private sector employers to terminate or freeze their traditional DB plans.
3. What are some advantages of CDC plans?
Many retirees can benefit from CDC plans because these plans offer a seamless and cost-efficient transition to a pension income stream. Plans may have access to lower cost investments and greater expertise than many individuals can secure on their own. In addition, CDC plans rely on the use of longevity pooling, which provides for benefit levels significantly higher than individual drawdown approaches.
4. How are benefit levels initially determined under a CDC?
There are several possible approaches:
- At retirement the initial benefit is determined by converting the account balance to an annuity based on investment and mortality assumptions.
- Another approach is to have benefits accrue during working years based upon a traditional DB plan formula but with adjustments along the way based upon plan investment experience. The benefit level at retirement then becomes the initial benefit.
- Other approaches are possible.
5. Are the initial income benefit levels guaranteed for life?
No, benefit levels vary because they are subject to investment and mortality experience. However, a CDC plan can be managed to provide that benefits continue for life, but not at a guaranteed level.
6. How does mortality experience impact benefit levels?
As noted above, benefit levels are determined based on the use of longevity pooling. The expected mortality experience of the group is used in the calculation of the initial annuity and in the periodic adjustments to reflect the actual mortality experience.
7. How does investment experience impact benefit levels?
Benefit levels are based on the expected performance of the plan assets. To the extent that investment returns exceed those expectations, increased benefits can be paid. If investment experience is less favorable, decreased benefits will be paid.
8. How are the assumptions selected?
Generally, assumptions are selected by the plan sponsor with the input of an actuary and other advisors. Assumptions are usually based on the expected returns of the actual plan investment portfolio and the expected mortality of the retiree group. Using more conservative assumptions than what is expected will allow for a smaller chance that benefits will need to be reduced in the future but will also provide for smaller initial benefits.
9. How are benefit adjustments for the actual investment and mortality experience determined?
There is no universal approach. Benefit adjustments can be determined fully on a periodic (often annual) basis or spread out over time. Experience gains could be treated differently from losses. The manner and timing of the adjustments would follow a specified plan.
10. Do the mortality and investment assumptions used ever change?
Yes. If the assumptions being used become unreasonable based on future expectations, changes to those assumptions are possible. This would lead to changes in the benefit levels being paid.
11. Does actual investment or mortality experience impact active participants who have not yet retired?
This can vary from plan to plan. A plan can be structured so that the plan acts like a traditional defined contribution plan, separate from the retiree group, before retirement income payouts. Alternatively, the plan can have experience shared among all participants. The latter approach can help to further smooth out benefit adjustments to retirees but could prove unpopular because of intergenerational equity concerns.
12. Who controls the investment selection?
This is a plan design feature. A single professionally managed portfolio can be used or retirees can choose among different portfolio options with varying asset allocations and associated risk/return profiles. Giving choice allows retirees to minimize benefit payout fluctuations (by opting for a more conservative investment portfolio) while allowing other retirees not concerned with fluctuations to potentially achieve greater benefits (through a more aggressive portfolio). Some plans allow active participants who are not yet retired to self-direct investments, but at retirement, funds are pooled with other retirees and professionally managed.
13. Why not just add insurance company products to DC plans to achieve a lifetime income?
There has been more emphasis on this approach during the last several years. For some retirees, this is a good choice. However, the pricing of annuities may be unattractive, especially in times of low interest rates. CDC plans can use a more aggressive investment strategy and thus may provide larger benefits (but with no guarantee). Insurance companies need to hedge against unexpected mortality experience, since the insurance company must guarantee the benefit level for the annuitant’s life. CDCs do not need to consider this hedging, since benefit levels are adjusted for actual mortality experience.
14. Can CDC plans pay out lump sums?
CDC plans can theoretically pay out lump sums at initial retirement, but generally not after that. Annuity forms are elected by the retiree and beneficiary (for example, life only, joint and survivor, or certain and life).
15. How is the plan funded?
The plan can be employee-funded, employer-funded, or jointly funded.
16. Are there CDCs now available in the US?
ERISA currently does not permit CDC plans. Variable benefits are permissible under both variable DB plans and DC plans but only if benefits vary based only on investment experience, not mortality experience. CDC programs can be found in other countries, such as Denmark, the Netherlands, and Canada and were recently made permissible in the United Kingdom. These plans are permitted in the United States under the CREF variable annuity option and under certain church plans, which are not subject to ERISA. Legislative changes are required for this plan design to be used in the private sector in the United States.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Mark Shemtob, FSA, MAAA, specializes at the policy level, plan level, and individual level in the challenges in securing and providing lifetime income brought about by the transition from defined benefit plans to defined contribution plans. He has written and spoken extensively on this topic and currently serves as a director to the Institutional Retirement Income Council. He can be reached at markeaasa@yahoo.com.