The Pensions Regulator has been paying increased levels of attention to how defined contribution (DC) schemes are governed. This, together with the trend for employers to provide DC vehicles (whether trust-based or contract-based) for future service, means that the spotlight is now, firmly, on DC governance. Challenges lie ahead (for instance, in relation to default funds and lifestyling) but much can be done by employers and trustees to address the issues with enough honesty about the time, effort and cost of effective DC governance.
Why is DC looking so attractive?
Although there are many employers sticking with defined benefit (DB) provision for plenty of good reasons, there are also lots of reasons for going DC. One key factor relates to certainty of cost, from the employer's perspective at least. For employees, the uncertainty of not knowing what they will end up with at retirement means that they will have to make plans from a more informed position than they might previously have assumed. Employers seeing their competitors moving towards DC are likely to feel more comfortable about making the same move. Plus, of course, the advent of personal accounts provides another opportunity for rethinking pension provision. Scheme design is creeping up the agenda now for many schemes. For those employers who do decide to go down the DC path, it's in their best interests to see their scheme working well. A workforce including staff who cannot afford to retire is likely to be less effective than one with a healthy level of staff turnover.
What are the challenges ahead?
Some recent research commissioned by the Department for Work and Pensions concluded that the majority of members invest in default funds which, for the most part, have lifestyling applied. In line with this, few members appeared to have much knowledge or understanding of the risks presented by DC and rarely sought information. As one would expect, the levels of engagement which trustees and sponsors had with their schemes varied.
However, in spite of low levels of financial knowledge in the average workforce, it's likely that many employees are sufficiently engaged to understand that a pension forms part of a wider package of employee benefits (such as childcare vouchers, death in service cover, health insurance and so on). The transparency of those other benefits can make pension arrangements look like an unsettling combination of smoke and mirrors so there is the challenge of increasing understanding, in the hope that members' faith in pension provision will grow.
Default funds are the focus of growing attention, especially with personal accounts just around the corner. Many trustees will probably compare their default fund arrangements with those of the personal accounts scheme. The automatic enrolment provisions do not allow employers to require eligible workers to make any choices (such as investment choices) before enrolment, so some default investment options would appear to be necessary. But how suitable will those funds really be for the members in question? Will they provide good value for money? Default funds tend to be weighted towards equities but with the advent of absolute return funds, for example, the options for a lower risk approach appear to be growing.
On the one hand, employers and trustees will want to be doing the best they can for their membership. On the other hand, we know that educating all members about the key financial decisions that they need to make on an ongoing basis would be a huge (and costly) undertaking, likely to meet with limited success. So perhaps a paternalistic approach broadly suitable for the majority of members is the best that we can hope for in the real world. For employers with an especially apathetic workforce, it may even be that limiting member choice simply to picking a retirement date would be the most appropriate way forward - simplifying member communications radically.
The Regulator's recently revised guidance on internal controls suggests, as an example of good practice, regular communications with members to explain the importance of reviewing investment choices and the risks posed by a volatile investment strategy in the run-up to retirement. Lifestyling is there to lessen the chances of nasty shocks, but it has its own issues. For instance, a member who has a second family in their 50s is unlikely to have the same priorities as someone in their fifties who is counting down to retirement with a nest free of children. It has often been mooted that lifestyling should operate by switching according to market strength, rather than age. It seems likely in the present economic climate that this kind of model will appear before too long and it is not hard to see the logic of such an approach.
Keeping everyone happy all of the time
With default funds and lifestyling one key question must be: how many profiles do you cater for? Working out your workforce's experiences is one thing, but doing the same in respect of deferred members is likely to yield far less information. If flexible retirement becomes the norm then the range of scenarios to take account of will multiply. The fact that the concept of a normal retirement date doesn't really apply to a DC scheme means, of itself, that other concepts such as lifestyling can be viewed as an artificial (not to mention prescriptive) construct, making it all the harder to explain to members.
Decumulation is the other big flashpoint for members seeking to maximise their pension pot. Would an annuity finder be the best option so that, for example, a single member doesn't end up buying an annuity including a spouse's pension? Again, though, there is a cost angle to getting advice about suitable annuities. In its recently updated guidance on internal controls, the Regulator says that trustees should support the member's decision-making process by sending "the right information at the right time". For example, the Regulator expects to see a clear statement about the open-market option, and suggests monitoring the take-up of that option. The guidance goes on to say that when delegating any aspect of the retirement process the key control objective for trustees should be "the best outcome for members". The "best outcome" isn't expressly defined but, judging by the controls suggested, presumably involves putting the member in a position where he or she can make an informed choice in an error-free environment (the controls suggested include timely and accurate communications, making sure that data is kept up to date and that benefits are calculated accurately and possibly providing access to an IFA, among other things).
Data protection presents its own challenges. In addition to the reputational risks associated with breaches of the Data Protection Act, from next April there will be the added risk of fines imposed by the Information Commissioner. The nature of DC provision means that there are, potentially, more opportunities for handling personal data than there would be under a DB arrangement (for example, whenever a member changes their investment choices).
What can you do about all this?
How can employers and trustees minimise the risks presented by DC?
Mistakes arising from administrative errors can be relatively easy for members to spot and more likely, therefore, to result in complaints. Equally, however, putting adequate checking systems in place should minimise these kinds of error.
Errors of judgement in relation to investment decisions, however, are harder to prove but have the potential, of course, to be of far greater significance. It may well be that as the number of DC members continues to increase, then greater numbers will question those investment returns more readily. What you actually do in terms of governance and how you describe that to members needs to dovetail (and this means not just at the time of writing your communications, but on an ongoing basis!). This can make the difference between a successful claim and one that becomes much harder to prove. Taking investment returns as an example, you should make sure that you don't overstate how often you monitor investments in your scheme booklet/other member communication.
When it comes to data protection, trustees and/or employers are likely to be classed as the data controllers and so will be responsible for compliance with the Data Protection Act 1998. It's therefore important that they understand what they need to do to comply and that they use the right tools to help them, such as:
- data protection notices (and consent forms where these are applicable - for example, where 'sensitive personal data' like medical information is processed)
- data processor agreements (with third parties processing data on behalf of the data controller)
- data protection policies (backed up with training), including policies on retention and destruction
- data protection registrations with the Information Commissioner's Office and
- security policies and risk assessments (of their own security and that of their data processors) plus a data security breach team, who can minimise the potential damage caused by a breach.
To tackle all these challenges, employers need to see what would work best for their particular workforce. Much can be done to address perception (is my pension safe? am I putting enough in? what are my options?). Part of the answer will lie in a scrupulous approach to governance applied in an intelligent way, by both employers (whether the arrangement is trust-based or contract-based) and trustees. The other part of the solution will require an honest appraisal by employers of the true cost of governing their DC arrangement and setting aside that cost at appropriate intervals.
The message is coming through loud and clear: there's more to DC than contributions!
Read about the latest state of play, in terms of work being done by the Pensions Regulator and the National Association of Pension Funds, in our alert Spotlight on DC governance - the latest state of play.