There has been a sea change in the expectations of the Pensions Regulator in relation to the way in which defined contribution (“DC”) arrangements are managed and governed, which is a reflection of the fact that DC is now the predominant basis of future pension provision for the UK workforce. Of those organisations participating in the 2008 Hewitt DC survey, 75% have DC as the only type of scheme open to new employees. This has steadily increased for each of the preceding years the survey has been carried out.

The average DC scheme value from the Hewitt survey is £12m, up from last year’s £8m, with 13% of respondents’ schemes having values in excess of £100m. This growing aggregate value of DC schemes, and the now significant proportion of the UK workforce in DC schemes, means that the potential issues arising from poor scheme performance and management are growing in real commercial terms.

In short, financial, regulatory, operational and reputational risks to businesses and trustees in relation to DC are increasing. This, in turn, requires far greater attention to these schemes from trustees and sponsors. For many sponsors, the competition for management resource often loses out to the significant demands of defined benefit (“DB”) arrangements, which require a high level of ongoing commitment to address the very real and pressing issues facing many such schemes.

It is interesting to consider the impact of the recent market volatility and uncertainty surrounding the security of some of our largest financial institutions and market structures, and compare the differences in focus from the trustee and employer perspectives between DB and DC schemes.

The financial health of a DB arrangement has a direct and potentially very significant impact on the sponsoring business, not just because poor asset returns and changing liabilities require reviews of funding, but also the extent to which the covenant provided by the employer to the scheme could be adversely affected by those same market forces. In some cases this creates a spiral of worsening funding, weakening of the employer covenant, and requirements for higher contributions or changes to the covenant structure that further undermine the best trading efforts of the sponsoring business.

In a DC environment, however, there is no link between the fortunes of the business and those of the funds underlying the basis of benefit provision as the ‘risks’ in DC have been passed on entirely to the members. There is no evidence at this time that employers look at reducing contributions for DC members, analogous to a cut in dividends for shareholders, indicating that these tend to be viewed as an element of an employee’s overall remuneration. There is the potential, however, that some employers may review the overall level of contributions following the introduction of Personal Accounts in 2012. This could be seen as a means of offsetting some of the cost increases to the business of the requirement to automatically enrol employees, particularly as the Hewitt survey indicates that this is only currently used as the method of scheme enrolment in 25% of schemes.

Although the risk of falling investment returns in a DC scheme is the most obvious one, it is not the only potential source of underperformance for members.

The Pensions Regulator has been helpful in identifying, through a consultation process reported on earlier this year, the risks to members of DC schemes:

  • Poor administration practices
  • Poor Investment practices
  • Unduly high charges
  • Poor decisions at retiremen
  • Lack of member understanding

All of these are identified as having potential to have financial consequences for members of the scheme. There are, however, consequential risks to the sponsor and/ or the trustees of these arrangements under each of these headings, as failure to monitor and manage these risks to members adequately, could result in claims against the trustee or the sponsor to recompense the member for the impact of an ‘unmanaged’ risk.

A good example of this would be to consider the scenario that an employer pays across a monthly contribution within 19 days of the start of the month following the month in which contributions were deducted from the employees’ pay, as is required under the Pensions Act 1995.

On receipt of the contributions the administrator applies the contributions to units in each member’s chosen fund and allocates these units to the member’s individual record. It is subsequently discovered, however, that the contributions deducted for those leaving service are not passed on to the administrator for the month in which they left, as the individuals do not appear on the member file for contributions being paid across in the following month.

In this example, the loss (measured by the exposure of each individual employee) might seem minimal. However, applying this practice over a number of years to a workforce of many thousands with a high turnover of staff could see a very significant aggregate liability to compensate those individuals. This is in addition to the time and cost spent identifying and tracing those affected, then calculating the loss in terms of both missed contributions and lost investment return.

It is evident from the significant increase in the proportion of schemes that maintain a register of risks (82% in this year’s Hewitt DC survey, up from 50% last year), that the issue of risks relating to DC schemes is growing in prominence. There are questions that need to be asked, however, on the degree to which the risks identified represent a complete list. The Pensions Regulator has produced a code of practice relating specifically to internal controls that sets out a helpful risk-based approach to identifying and managing risks in this area.

The major challenge, having identified a risk, is how to monitor that risk accurately to enable early remedial action to be taken. It is critical that trustees and plan sponsors have access to timely and complete management information from the various parties to the scheme. Furthermore, it is important that the information presented in those reports relates directly to the risks against which the scheme’s objectives have been set.

It is arguable whether the providers of services to the scheme are best placed to report on their own performance, particularly when there are qualitative assessments that need to be made, and in some cases benchmarks in relation to performance that should ideally be presented in the context of the market as a whole.

In conclusion, it is evident that the growth in asset size and population coverage of DC arrangements in the UK, together with the greater regulatory focus in this area, have the effect of:

  • increasing the real risks to sponsors and trustees in relation to DC schemes; and
  • increasing the expectations of the Pensions Regulator as to how these risks should be measured and managed.