The Pensions Regulator is increasingly focusing its attention on the governance of defined contribution (DC) schemes and DC sections of hybrid schemes. The trustees of such schemes ought to review their governance arrangements in light of the Regulator’s recent statements which outline the standards it expects from the trustees of such schemes. Trustees of DC and hybrid schemes also need to consider the impact of the new legislative definition of “money purchase benefits” on their scheme.

Background

Over the past decade there has been a significant shift in the pensions landscape, with a reduction in the number of open defined benefit (DB) schemes and an increase in DC provision. This trend is only likely to continue with the introduction of automatic enrolment. It comes as no surprise, therefore, that the Pensions Regulator is increasingly focusing its attention on the governance of DC and hybrid schemes.

The role of trustees in DC schemes

In its recent statement ‘The role of trustees in DC schemes’, the Pensions Regulator outlines its expectations of trustees of such schemes. Prompted by concerns over the governance standards of DC schemes, the statement calls for an improvement in the level of engagement by DC trustees in the running of their scheme. The Regulator also makes clear that it expects “trustees to embrace the behaviours outlined in this statement”, which include the following:

  • Knowledge and understanding - Trustees must have sufficient skills to manage the scheme effectively. They must formally assess the capabilities of the trustee board and manage knowledge gaps promptly.
  • Managing conflicts of interest - Trustees must ensure that non-trivial conflicts of interest are suitably managed and disclosed and should produce a conflicts of interest policy.
  • Costs and charges - Overall charges levied to pension schemes often lack transparency. Trustees must understand how their scheme’s charging structures operate and determine what levels of charges are paid by members. Charging structures must be applied fairly to all categories of membership. The Regulator does not view active member-only discounts (or deferred member penalties) as being fair and, therefore, acceptable.
  • Investments - Trustees must formally and regularly review the range and appropriateness of investment funds available to members under a DC scheme. In particular, they must assess the appropriateness of the default fund and ensure that it complies with default fund guidance issued by the Department for Work and Pensions.
  • Asset protection - Trustees must invest prudently and they must predominantly invest scheme assets so that they are managed by entities registered with the Financial Services Authority (FSA) or similar regulated authorities. Where trustees offer unregulated investment options they must be able to demonstrate why this was appropriate, why the level offered is prudent and must clearly communicate this information to members. In the absence of a financial guarantee, trustees must establish what compensation arrangements are available in the event an investment provider defaults and they must understand the protection available to members under the Financial Services Compensation Scheme (FSCS) and carefully consider situations where compensation is not available.
  • Administration - Trustees must devote sufficient time to manage their scheme, including meeting regularly (e.g. at least quarterly) to discuss governance issues. Trustees must be able to demonstrate that they have assessed key risks to their scheme and document how these are managed in a risk register. Trustees must put in place measures to ensure the accuracy of scheme records and they must continually assess the quality of administration and record-keeping and seek assurances that outsourced services are operating effectively.
  • Contributions - Trustees have a legal duty to ensure that contributions are accurate and paid over to the scheme on a timely basis. Trustees must ensure that contribution processes and controls are ready to respond to the increased demands arising from automatic enrolment. Trustees must take reasonable steps to pursue and resolve all late payments. In addition, the Regulator places responsibility on trustees to ensure members are aware of the impact contribution patterns will have on the overall size of their pension fund.

Over the coming months the Regulator intends to publish a series of statements and tools which will help define the criteria of a good DC scheme or product. In the longer term, the Regulator plans to develop an operational framework which will enable it to determine compliance with standards of good practice and behaviours.

Understanding and managing hybrid schemes

With the introduction of automatic enrolment from October 2012 the Regulator anticipates that the number of DC members in hybrid schemes will increase. The Regulator, therefore, wants to ensure that the risks associated with hybrid schemes are understood and managed. In particular, the Regulator’s statement, ‘Understanding and managing your hybrid scheme’, identifies the following potential risks to members which should be addressed:

  • Lack of governance - The Regulator is concerned that trustees are spending insufficient time considering the DC element of hybrid schemes and it urges trustees to spend appropriate time on the different benefit elements within their scheme.
  • Unclear and incorrect member communication - The Regulator is concerned that the complex nature and structure of hybrid schemes may lead to unclear and incorrect member communications and members’ benefits being calculated incorrectly. In addition, in a recent survey of hybrid schemes by the Regulator only 73% of the schemes surveyed stated that they provide a statutory money-purchase illustration to their DC members. The Regulator expects trustees to comply with their legal requirements in this regard.
  • Separation of DC assets - The Regulator’s survey showed that over 50% of hybrid schemes were using the same bank account for DB and DC assets and that a high proportion of schemes could not, at any given time, identify which monies belonged to which members of the scheme. This poses a significant risk to DC members, as it makes it difficult to segregate the assets when benefits are paid or when a scheme goes into wind-up (where DC assets must not be used to secure DB benefits).
  • Pension Protection Fund (PPF) levy - The Regulator is concerned that some schemes are paying the PPF levy in respect of DC members who are not eligible for PPF protection. The Regulator expects trustees that have not already done so, to verify with their scheme advisers that the correct information is being provided to the PPF, so that the levy is not being paid in respect of members who would not be eligible for PPF protection.
  • Inappropriate investment strategies – The Regulator is concerned that trustees are adopting inappropriate investment strategies for DC sections of hybrid schemes, with a third of hybrid schemes surveyed by the Regulator saying that they use similar investment strategies for their DB and DC sections.
  • Requirements on retirement options - Only 73% of hybrid schemes surveyed by the Regulator offer the open market option to DC members on retirement, despite being under a legal obligation to do so. The Regulator expects schemes to fully comply with this requirement.

The Regulator’s statement contains checklists to help trustees, scheme administrators and other scheme advisers to run hybrid schemes effectively. From November 2011, the scheme return for DB and hybrid schemes will include additional questions to enable the Regulator to understand and monitor these schemes more effectively.

New definition of “money purchase benefits”

The introduction of a new statutory definition of “money purchase benefits” is likely to have significant implications for some DC schemes and DC sections of hybrid schemes. The new definition, which has been introduced in response to the recent decision of the Supreme Court in the case of Houldsworth v Bridge Trustees, essentially provides that a benefit will only be treated as a money purchase benefit for the purposes of pensions legislation where it cannot give rise to a deficit. This means that some benefits which may have traditionally been treated as DC benefits (e.g. DC pensions paid by a scheme by way of internal annuitisation and DC benefits with a guaranteed investment return or some other form of underpin) may now have to be treated as defined benefits and be subject to the statutory funding and pension protection regimes that apply to such benefits. They may also no longer be insulated from the effects of an insolvent scheme wind-up.

The new definition of “money purchase benefits” is enshrined in the Pensions Act 2011, which is due to receive Royal Assent today. Further detail on the precise application of the new definition is expected through regulations which will be issued in due course. It is important that trustees of DC and hybrid schemes consider the potential impact of this new statutory definition on their scheme and, in particular, consider whether any of the benefits that they have historically treated as DC benefits may in future be subject to the legislative requirements that apply to defined benefits.

For more details on the new statutory definition of “money purchase benefits” and the case of Houldsworth v Bridge Trustees see our speedbrief of 17 October 2011.