The Department for Work and Pensions issued its Money Purchase Command Paper ("Command Paper") in March, setting out its proposals to improve the quality of workplace DC schemes. The Command Paper covers both trust-based and contract-based schemes, with the main emphasis being on governance and fees. The Government's focus on DC schemes has been apparent from a number of consultations over the course of 2013, reported on in our November 2013 edition of Pensions Pieces1. These have informed the DWP's understanding of the issues to be addressed by the proposals set out in the Command Paper, which itself consults on further proposed measures. Indeed, the Command Paper constitutes the Government's formal response to a number of the 2013 DC initatives1.
There is already new legislation contained in the Pensions Act 2014 to establish the framework for a number of the proposals, with secondary legislation containing the detail to be laid before Parliament towards the end of 2014. The majority of the proposals are due to be implemented with effect from April 2015.
The key measures being introduced are:
- a requirement for contract-based schemes to have an Independent Governance Committee ("IGC") in place, to take on a role equivalent to that of a trustee board;
- new governance obligations on the trustees of trust-based schemes;
- a requirement to report on costs and charges in a standardised format for all workplace DC schemes; and
- a charge cap of 0.75% for all default funds of schemes used as "qualifying schemes" for the purposes of automatic enrolment.
The minimum quality standards that are to apply across workplace DC schemes are as follows:
- All schemes must be governed by a body with a duty to act in members' interest.
- The governing body must be able to freely exercise its duty to act in members' interests and must be able to explain how any conflicts of interest are handled.
- The majority of individuals – including the chair – of the governing body must be independent of the pension provider (in fact restricted to master trust boards and IGC's in the detail).
- The governing body must consider:
- the design and net performance of default investment strategies;
- standards of administration;
- charges borne by scheme members; and
- costs incurred through investment of pension assets.
- The governing body must have – or have access to – all of the resources, knowledge and competencies necessary to properly run the scheme.
- The chair of the governing body must produce an annual report explaining how the scheme has performed against the quality requirements.
There are slight variations in the standards that apply to trust-based and contract-based schemes, as explained in the following sections.
New minimum quality standards for trust-based schemes
The DWP recognises that the trust-based model brings the inherent advantage to members that there is a trustee body responsible for running the scheme in members' interests. However, the DWP remains concerned about governance and administration standards, particularly in smaller, single employer schemes. The DWP also has reservations about the independence of trustee boards in certain master trusts.
The new quality standards
To address these concerns, the DWP proposes new minimum quality standards for occupational DC schemes, which are very similar to those that will apply for contract-based schemes. Perhaps in recognition of the fact that simply issuing yet more guidance is unlikely to drive meaningful change2, the quality standards will be set out in legislation. This legislation will enable the Regulator to enforce compliance. The proposed quality standards as applied to trust-based schemes are as follows (as set out in the Command Paper):
- All schemes must have a chair of trustees.
- Default investment strategies must be designed in the interests of members, with a clear statement of aims, objective and structure and how these are appropriate for their membership.
- The characteristics and net performance of default options must be regularly reviewed to ensure alignment with the interests of members, and action taken to make any necessary changes.
- Core scheme financial transactions must be processed promptly and accurately.
- Trustees must assess the levels of charges borne by scheme members.
- Trustees must assess the costs incurred through investment of pension assets.
- The trustee board must have, or have access to, all of the knowledge and competencies necessary to properly run the scheme.
- Trust deeds and rules must not require trustees to use particular investment or administration providers, or to make particular investments.
It is proposed that these standards, and a duty on the Chair of Trustees to report on compliance with them in the annual report and accounts, will be set out in legislation to come into effect in April 2015.
The DWP hopes that the requirement for each trust-based scheme to have a named Chair (including on boards of corporate trustees), who is responsible for reporting on how the standards are met, will drive compliance. The requirement for the report to be included in the scheme's audited annual report and accounts is intended by the DWP to provide an additional layer of assurance, as the auditor is expected to provide oversight on whether compliance has been achieved, and to carry out a whistleblowing function where there have been breaches.
Additional requirements for master trusts
Additional requirements are proposed to apply to master trusts, as follows:
- Master trust boards are to have a minimum of seven trustees, the majority of whom, including the Chair, are independent of the providers of services to the master trust.
- The scheme must have arrangements in place to ensure that members' views are directly represented.
This is intended to ensure that the trustee board operates independently of the provider. In addition, the requirement that the scheme documents must not require trustees to use particular investment or administration providers will be of particular relevance to master trusts.
A number of the new quality standards largely reflect the duties already on trustees, either through existing legislation or through the "common law" duties that have developed through the courts as trust law has evolved. However, the new quality standards are likely to lead to a greater focus on certain areas of DC governance. Key areas to consider in advance of April 2015 are as follows:
- With regard to investments, there will be a specific requirement, to be reported on annually, for active oversight of the default fund. This may require trustee boards to revisit their processes, to check that there is sufficient oversight of the fund in place on an ongoing basis. Trustees will also need to consider what steps they could take in the event that the fund in place became unsuitable, so that they are ready to act if necessary. For instance, would the rules of the scheme enable the trustees to move existing default fund members into another fund without their consent?
- It will also be necessary to put in place a statement of the "aims, objective and structure" of the default investment strategy, and to state how this is appropriate for the scheme membership. It is likely to be necessary to revisit the SIP in order to confirm that it covers these areas.
- Schemes with documentation that was originally drafted by a pension provider or administrator should be checked to ensure that the trust deed and rules do not specify particular investments or investment/administration providers. Although this requirement was probably included with master trusts in mind, it may also catch a number of older schemes whose rules were drafted by a provider or administrator.
- The requirement that core scheme financial transactions must be processed "promptly and accurately", as set out in the quality standards, simply codifies the existing duty on trustees in this regard into legislation. However, it is proposed that additional guidance will be provided, which is likely to include more detail on the Government's expectations in this regard. Following consultation, the DWP decided against enshrining specific timescales for different transactions in the legislation, given the risk that these would fail to keep pace with developments in administrative practice over time.
- The Government is also looking at other ways of promoting improvements in administrative standards. In particular, the DWP wishes to encourage schemes to take advantage of the Pensions Administration Standards Association (PASA) accreditation programme for pension administrators.
Costs and charges
- Trustees will be obliged to assess the charges borne by scheme members and the costs incurred through the investment of pension assets, and to provide information about headline charges and costs annually as part of the annual benefit statement. This is intended to be the first step in a drive towards greater transparency and standardisation of reporting on costs and charges.
- In order for trustees to secure value for money, the DWP recognises that it would be of assistance to trustees to be provided with information on costs and charges in a clear and consistent format. It is proposed that providers will be required to provide full information to trustees in a standardised and comparable format, which should assist trustees in carrying out their own analysis. No timetable has been specified for this.
Skills and competence
- The DWP decided against setting a quota of board members that have to have particular qualifications. Instead, the Chair's annual report will need to include a statement about how the trustee board as a whole either has, or has access to, all the skills and knowledge required to run the scheme properly. The DWP states that this should include an assurance that each trustee has met their trustee knowledge and understanding requirements in accordance with section 247 of the Pensions Act 2004, as well as a broader assessment of the knowledge and competencies across the board as a whole.
- Helpfully, the requirement recognises that professional advice is one way in which a trustee board can access the required skills and knowledge.
What the DC Command Paper means for contract-based pensions
One of the biggest changes to the pensions industry the Command Paper has proposed is the harmonisation of obligations and quality standards across the entire industry, meaning that for the first time contract-based schemes will be caught alongside trust-based schemes.
The minimum standards proposed for all schemes (covered above) represent a good improvement from the member perspective, but how will this impact the contract-based market?
Well, as the Command Paper notes, contract-based schemes are not necessarily a bad thing, offering benefits of scale and professionalism of services. But both the DWP's call for evidence and the OFT's analysis highlighted that their primary downside is that in a contract-based scheme set-up there is generally no-one whose job it is to protect the members. This is obviously a stark contrast to the trust model, which as its heart is based on the principle that someone is acting in the best interests of someone else for whom they are responsible. The focus therefore is the introduction of new governance arrangements to ensure the independent oversight of contract-based schemes, with members' interests as its foundation.
Independent Governance Committees
After the OFT's report, the Association of British Insurers (ABI) agreed with the OFT that its members would introduce independent governance committees (IGCs) on a mandatory footing covering such key elements as independence, expertise and power.
The Government welcomed this and has stated it intends to take this agreement further by making IGCs compulsory via Financial Conduct Authority (FCA) Rules, the aim being to ensure consistency across all providers. So IGCs will be required at provider, not employer, level. Of course this does not stop employers establishing their own IGC as well but this is not what the Command Paper requires.
What will their objective be?
The key objective will be to act in members' interests through assessing and reporting on value for money delivered on an ongoing basis. As with trust-based schemes, this will mean looking at the quality standards – whether default strategies are for the interests of members, whether the performance of default investments is aligned with the interests of members and whether costs and charges are fair, as well as the speed and accuracy of core scheme financial transactions.
One of the concerns about what real value provider IGCs will add was who they are really looking out for. The Command Paper lays any doubt on that issue to rest stating that there should be an explicit duty to act in members' best interests. There is however, recognition that this may be a difficult task when you are talking about, typically a large diverse group of members. The situation is compared with that of trustees of large master trusts, and, whilst difficult, is not considered insurmountable.
Whilst the Government is keen on explicit duties for IGCs, it has not chosen to follow the calls for an explicit duty on the providers themselves to act in members' best interests. It believes that a duty on IGCs coupled with the "comply or explain" duty on providers that the OFT favoured3 will be sufficient to achieve aimed-for improvement in DC quality.
The other big concern about IGCs is whether they will have enough clout to ultimately be effective. The Command Paper has reiterated this point and backs the OFT model of having IGCs make recommendations to the pension provider about value for money being delivered. The crucial point here is that IGCs will have the power to make their recommendations public to members and employers and also to report failures to follow their recommendations to the FCA. The FCA will, in turn, change its rules to give it the powers to control and regulate as necessary.
IGCs will not have the power to make decisions about how a scheme is run. This was given consideration but the Government felt that an IGC could sustainably not have both true independence and at the same time the executive powers to be able to control the running of the provider's pension scheme. Essentially, the Government did not want there to be any scope for independence being tarnished given how integral this is to acting in members' best interests.
New FCA rules ahead
Obviously, the key to making this stricter regime work will be the threat of relevant regulatory action. As such, the FCA rules will need to change and it is due to consult on draft changes later this year.
The revised rules would firstly see providers having to have an IGC on a mandatory basis as well as fully considering all the IGC's recommendations when in place. The emphasis will be on acting on those recommendations unless it is not possible to do so. If the provider cannot comply it will have to explain why to the IGC and if the IGC is not satisfied, it will be able to report to the FCA as well as notify scheme employers and members.
Composition and resourcing
Independence is vital and the Command Paper sets out that as well as the majority of members being independent, so must the chair of the IGC be. To be "independent" a member must not be an employee of the provider or have been so within the last 5 years, or have had a material business relationship with the provider within the last 3 years. Furthermore, the IGC as a whole should keep its individual members under review to ascertain if there are any relationships or circumstances which might affect judgment at any particular time.
Two things the Command Paper also stipulates are for the IGC to be provided with sufficient resources to obtain access to professional advisers and also access to all relevant information from the provider to be able to assess value for money, even if that might be commercially sensitive.
Work still to be done
One of the things that came out of the consultation was a concern over whether it will be possible to make changes to investments because of pre-existing contracts, even if it would be best for members. The Command Paper recognises the problem, that some schemes may be restricted contractually in a way that trust-based schemes are not, but, for now, parks any proposed solution pending the outcome of the OFT's audit of high cost and legacy schemes. Following that review it may be necessary to consider further government intervention and legal changes so that members in poor value vehicles are not just left there to rot because of contractual inflexibility.
Between new FCA Rules, IGC terms of reference and the OFT's audit, we can expect to see a lot more of the details in the coming year, and only time will tell how well these aspirations will work in practice from both the members' and providers' perspectives.
Cap on fees for default funds
The DWP plans to impose a cap on member-borne charges that may be levied on DC default funds under schemes that are used as "qualifying schemes" for the purposes of the automatic enrolment requirements. This is in recognition of the significant impact that charges have on fund performance overall. The cap is being limited to default funds on the basis that higher charges may be necessary to access active management or certain alternative asset classes. Limiting the cap to default options means that schemes can still provide such options for members who actively wish to switch fund to take advantage of them.
The cap has been set at 0.75% of the fund value of the default fund in qualifying schemes and is proposed to be introduced from April 2015. It will apply to all member-borne deductions paid to the pension provider or another third party, excluding transaction costs (the trading costs a scheme incurs when buying, holding and selling underlying investments). Any commission or active member discount structures (before these are banned in April 2016) must not take member-borne charges above the 0.75% threshold.
Certain schemes offer additional services to their membership for a fee, such as annuity broking and advice, loyalty bonuses and protection benefits such as disability, incapacity or life cover. The DWP states that, following the charge cap, additional services or cover can still be provided and charged for, but this must be on an opt-in basis.
What is a "default fund" for these purposes?
Where new members are being automatically enrolled into a pension scheme, the default fund that applies to them will be obvious. However, for legacy schemes and for past joiners of existing schemes, it may not be clear whether or not a default fund applies. In the Command Paper, the DWP suggests that where there is no specifically nominated default fund, the cap should be applied to the fund with the greatest number of members from each saving cohort (noting that there may be concentrations of members in different funds, based on what was made available when they joined the scheme). This is likely to extend the cap to funds on offer beyond those we would generally consider to be a "default" fund, perhaps to the options most frequently chosen by particular cohorts of a scheme's membership over time.
How was the level and scope of the cap chosen?
The 0.75% cap was chosen in recognition of the fact that charges in general have fallen since the 1% stakeholder cap was introduced in 2001. Although average charges are presently lower than 0.75%, setting the cap at this level is intended to provide flexibility to allow smaller funds which do not benefit from economies of scale to continue to be provided, and to allow some margin to enable a variety of investment options to be provided within default funds. The Government will consider in 2017 whether some or all transaction costs should be included in the default fund charge cap and whether the level of the cap should be lowered.
There were certain challenges in designing the cap. This is because of the variety of charges in the workplace pensions market. One respondent to the OFT consultation, Hargreaves Lansdown, described a "water-bed" effect, whereby pushing down on costs in one area could lead to them popping up elsewhere. In view of this risk, the proposed charge cap will apply to all costs and expenses taken from member pots in default funds, with the exception of transaction costs. The reason for the exclusion of transaction costs is that they may vary considerably across asset classes and markets, and limiting the costs default funds could incur could prevent trades in times when they might be required for the benefit of the portfolio (for example, in circumstances similar to the financial crash of 2008).
In order to help trustees and IGCs compare and control costs of different providers, there will be new reporting requirements on providers to disclose costs and charges from April 2015 (it is unclear exactly which providers these reporting requirements will apply to). These will involve a requirement to disclose all costs and charges (both administration and transaction costs) in a standardised, "line item" format to trustee boards and IGCs, to allow full comparability on a consistent basis.
Trustees will need to consider the expense provisions in any default funds. Where expenses are met from members' funds, it will be necessary to ensure that they do not exceed the 0.75% cap from April 2015, or – on the basis of the proposals as set out in the Command Paper - the scheme will no longer meet the requirements to be a "qualifying scheme" for automatic enrolment.
Further measures on commission, consultancy charges and expenses
Member-borne commission is to be banned from April 2016. This is being delayed until after the charge cap is in place to give more time for affected parties to renegotiate remuneration for work done.
These charges will be banned from April 2015, including where existing arrangements are in place.
Transparency on expenses
In addition to the annual report on costs and charges to be included as part of the annual benefit statement, there are more general proposals to require providers, trustee boards and ICGs to report on both administrative charges and transaction costs in a standardised way, to allow greater comparability. Information on schemes' costs and charges is also proposed to be made publicly available, to assist employers and members/prospective members in assessing value for money. No specific timetable has been set for these requirements.
The DC pensions market is in a period of significant change, both in the context of trust-based and contract-based arrangements. This will be a challenge for all participants in that market – for example, employers considering the most appropriate pension arrangements to have in place, particularly to satisfy their automatic enrolment obligations and trustees who are most likely going to have to comply with new legal duties that are going to be imposed on them in relation to their scheme governance. This too is compounded by the relatively short timescales in which the changes are going to be imposed (in some cases as early as April 2015). In view of that, all parties would be well advised to familiarise themselves with the proposals and start to consider how systems might be set up to ensure compliance if and when the proposals are formally introduced.