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- Good governance around contract-based DC pension schemes can be clarified under four broad headings: scheme initiation, scheme design, monitoring and member communications.
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A clear plan of objectives will put employers on course to ensure good governance around a contract-based DC scheme, says Ceri Jones
The Myners principles on institutional investment helped clarify good governance for final salary pension schemes, but there has been a gap around best practice for work-based defined contribution (DC) plans. To address this, the Investment Governance Group, an industry body sponsored by the Department of Work and Pensions and chaired by The Pensions Regulator (TPR), was set up to give guidance on best practice for DC schemes. It published a consultation paper in February containing guidance and a table of accountabilities to help employers make decisions. The consultation is due to close on 5 May.
The good news is there are no hidden traps and relatively few differences of opinion as to what constitutes good governance around contract-based DC pension plans. The consultation clarifies practice under four broad headings: scheme initiation, scheme design, monitoring and member communications.
When a scheme is set up, for example, an employer will have to decide whether to form an investment committee, a feature that will become increasingly common. The design stage covers the investment configuration and default fund strategy, plus the generation of a governance plan setting out the delegation of duties.
Legal and regulatory framework
Ongoing monitoring deals with compliance with the legal and regulatory framework and the day-to-day administration, as well as the performance of investments. Employee communications includes the explanation of investment choices, performance updates and information on their retirement options. The latter, which covers information such as the different types of annuity available, is the area that is most overlooked by employers.
However, there are challenges around who should shoulder responsibility for some of these issues, particularly concerning investment. There are differences between DB and DC schemes. For example, monitoring investment performance is the responsibility of the trustees in DB schemes, but in DC plans it falls to the employer, with input from professional advisers and, often, the provider. That balance of responsibility can shift further towards the provider and adviser where arrangements involve funds of funds or a blend of funds.
Governance gap
Kevin Painter, principal at Mercer, says: “It is recognised by the regulator that there is probably a governance gap, and a lot of material focuses on the dynamics between employer, provider and trustees. Trustee duties in DB are clearly articulated, but it is more problematic in DC because accountability will fall to the employer, and the provider if it is a bundled arrangement.
"The key thing for employers is to be clear what the objectives are in setting up a new arrangement, and the level of commitment it wants to invest in issues such as benefit adequacy, investment options and communications. The areas where governance is generally efficient are the quantitative areas such as defined outputs, service standards, and the proper allocation of contributions and withdrawals within the correct timescales. The areas where more effort is required are the qualitative areas, which, by definition, are difficult to measure."
A first sensible move is for employers to define their objectives with targeted measures. They should then take a look at these structures at least once a year, and undertake a full review with the scheme consultant every three years.
Mercer's 2009 Global Defined Contribution Survey showed the top success factor for an employer in setting up a DC scheme was that it should be valued by employees. But although 78% of respondents said this was their prime success gauge, only 16% of employers believed their schemes were valued by employees. More than one-third (34%) of employers had no objectives and 46% had no defined success measure. Almost 30% had no documented policy. A governance plan should clarify the various responsibilities, which should then be communicated to members. At this stage, the employer may decide whether to set up a governance committee.
David McCourt, senior policy adviser, investment and governance at the National Association of Pension Funds (NAPF), says some plans have already set up a governance or management committee specifically for the DC section of their pension schemes, quite independently of any DB legacy scheme.
Separate focus needed
"A separate focus is a good thing because the DC element will still be small compared with the DB scheme, where the focus will be on deficits and funding levels, which would probably otherwise take all the attention," he says. "A separate body will be able to focus entirely on how DC will develop.
"The constitution of the committee is critical. It will be split into employees, who are elected, and employer representatives, who are appointed. But that may not be so easy if none of the DB trustees are themselves members of the DC scheme, because other members could question why this person is involved. On the other hand, most DB trustees do have DC experience in running additional voluntary contributions [AVCs]."
David Pitt-Watson, chairman of Hermes Focus Funds, says: "This is terribly important. You need genuine expertise because the issues are complicated, but you also need to be careful of loading the board with exclusive expertise because you need to have someone batting for the beneficiaries, and lay trustees can often bring welcome common sense. The events of 2008 demonstrate the danger of group thinking."
Expertise in the boardroom
There is a danger that boardrooms can be full of expertise but have limited practical sense. According to consultants, it is often lay trustees who ask the right questions and come up with the most radical thought processes or solutions.
Several facets of scheme design will follow naturally from a frank appraisal of the time and effort an employer wants to put into pension provision, particularly how far to build elements of auto-pilot into a scheme. Painter says: "An important point is for the employer to recognise the different categories of employees so they can decide how much auto-piloting should be built into the arrangement, such as an automatic increase in contributions on an annual basis, perhaps timed to coincide with pay reviews. For example, if a fair degree of auto-pilot is required, there may be a need to ensure the default [investment] option is best in class."
In investment, the objective is to provide an appropriate number of fund options and describe them in a format that is easily understood. Most employers setting up contract-based DC schemes from scratch limit their funds to a core range of six to eight so as not to confuse members. Some employers have gone further, using white labeling to make funds' objectives easier to understand. A trend is also beginning to use blended funds with different fund managers, which involves the trustees and governance group working with professional investment advice. These products can be highly sophisticated but still look simple to the employee.
One point that may not be immediately obvious is that where a fund range has been restricted, an audit trail should be put in place to justify and explain how those decisions were made. The Pensions Regulator has said this needs to be communicated to members. An annual governance report from a provider should detail the scheme's strength, membership movements, default fund take-up and use of communication tools such as the number of hits on the website, use of the helpline and modelling tools. Employers should then communicate this to members.
Don't overegg governance
However, it calls for a fine balance not to overegg the governance provisions. “DC is very much a work in progress, changing all the time,” says the NAPF’s McCourt. “What is appropriate to one scheme may not be to another. Governance should be appropriate to the size of the scheme. The danger is that employers can extend it out and have subcommittees on risk and investment, and so on, but it is important not to do things for the sake of it, or because others are doing it. The structure should be reviewed properly. A number of firms offer governance and trustee board review services.”
Clive Grimley, a partner at Barnett Waddingham, concludes: "It is a question of quantum. The employer probably put a DC arrangement in place to avoid doing so much of this stuff and will want to give due recognition to the regulator, but will not want to replicate the work in the DB scheme."
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CASE STUDY
Yorkshire Water has several schemes on tap
Yorkshire Water runs several legacy pension schemes as well as a contract-based stakeholder arrangement, Pension Saver, which was brought into a salary sacrifice wrapper in October 2008. This was introduced via a series of roadshows run by the in-house pensions manager and administrator, and a modelling tool, developed by Mercer, was made available on the company intranet.
New recruits become members of the scheme unless they actively opt out, so more than 70% of the workforce are active members. Staff who earn below the national minimum wage or the lower earnings limit are flagged in a monthly check, undertaken by the payroll department. This reduces the likelihood that staff will pay into the scheme only to lift themselves out of means-tested benefits.
Kathryn Nolan, assistant manager, HR, resourcing at Yorkshire Water, says: "At various times, we look at the pension scheme take-up and send out flyers with payslips, or place items of interest on the internet if we think that will encourage members to engage with their pension."
A flexible retirement option allowing employees aged over 55 to phase in their retirement is explained in presentations to staff aged 48 and over.
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SHAREHOLDER ACTIVISM
Shareholder activism is an area long associated with defined benefit (DB) pension schemes, where large segregated mandates can confer a big shareholding in a quoted firm. However, best practice in shareholder activism applies equally to defined contribution (DC) pension schemes, although it may not be so obvious, because the shareholders are the direct beneficial owners.
David Pitt-Watson, chairman of Hermes Focus Funds, says: "For most DC schemes, this amounts to challenging what the fund managers are doing, for example, if they are hedge funds, are they incentivised over the same time-frame as the pension, and is the strategy transparent? A step further is to invest a small portion in a shareholder activist fund, a step the member can profit from because a badly-run company is worth less than a well-run one."
Fund managers should be audited against the code drawn up by the Institutional Shareholders Committee, gauging the real level of their commitment.
Read more articles from Special report 2010: contract-based pension governance