If you read nothing else, read this…
• Employers have no legal obligation to ensure the investments of members in contract-based defined contribution schemes are on target for retirement.
• But employers should educate staff about the level of contributions required to build a decent fund.
• Communications should be kept simple so staff read and understand them.
• Pension modelling tools help to forecast the impact contribution levels and investments have on a fund.
• Structure of the default fund is critical.
Case study: ICE engineers membership rise
The Institution of Civil Engineers (ICE) closed a defined benefit (DB) pension scheme with 60 members and a trust-based defined contribution scheme with 110 members at the end of last year, and replaced them with a single group personal pension plan provided by Scottish Life. Since then, membership has risen by over 30% to 225 policyholders and the average contribution has risen from 5.6% to 7.6%, with the employer matching to 8%.
One reason for the better engagement is that all staff received one-to-one advice with adviser Secondsight, which was partly paid for by the plan’s annual charges and partly as an ongoing fee paid directly by ICE.
This was used to explain the level of contributions required to build a decent pension and asked members to put themselves into one of five risk categories, which were then matched against five lifestyle funds. One-quarter of members chose the option for automatic increases so the average employee contribution will rise to 9.2% over five years.
Ethan Kelly-Wilson, head of HR operations at ICE, says the organisation had been paying 26% of each employee’s salary into the former DB scheme. It had also been contributing an additional £1 million a year since 2008 to reduce its £2.5 million deficit.
“We have been able to fund a lot of what we have done by the £100,000 of savings closing the DB scheme created in the first year, as well as vamping up staff benefits, such as private medical cover and improved maternity and paternity benefits,” he says.
Employers must ensure DC pension scheme members are clued up on their fund’s investments, says Ceri Jones
Currently, employers are under no legal obligation to make sure the investments of members in contract-based defined contribution (DC) pension schemes are on target for their retirement. But that could easily change, because The Pensions Regulator has been stepping up its interest in DC scheme governance, and there is much to be done if a generation of workers are not to be disappointed with their DC pension benefits.
The regulator has been very active in recent years, reviewing scheme literature and periodically surveying plans and reporting the findings. In November 2010, the Investment Governance Group (IGG), a joint initiative between the industry and The Pensions Regulator, distilled this work into a framework of principles and best practice to help those running work-based DC schemes. The main principles cover responsibilities, decision-making, investment options and default strategy, monitoring investment performance, and communication.
Mark Jaffray, senior investment consultant at Hymans Robertson, says: “This new set of guiding principles previously applied only to trust-based schemes. They encourage a high level of governance, and an organisation looking at that may think it is too onerous and decide to rely on the provider instead, but it is no longer possible to do that. The IGG has been vociferous about setting up committees to look at the decisions members make around fund choices, retirement age decisions and, recently, on the options available on conversion into an annuity.
“At the time, there was some debate about whether these principles would be regulatory or best practice and whether the regulator would audit schemes to check if they comply. But the regulator backed away from making the principles compulsory, and auditing schemes, possibly because the CBI [Confederation of British Industry] brought pressure to bear and the economic climate is difficult.”
Most advisers believe the guidelines are a good framework for employers to follow. Anne Swift, head of DC investment, UK benefits solutions at Aon Hewitt, says: “Employers cannot hold their employees’ hands and give them advice, at least not directly, but they can build a robust process to ensure the funds on offer, and the default, are suitable for their workforce, and that members are fully equipped to make an appropriate choice. This includes ensuring they provide, directly or through a provider or adviser, good employee education and communication, using appropriate media for their particular workforce.”
The first step is to educate employees about the true level of contributions required to build a decent pension. As a rough guide, contributions as a percentage of salary should equal about half of someone’s age to achieve a pension of half to two-thirds of their final salary. Richard Butcher, managing director of Pitmans Trustees, says: “It seems to me many members are heading towards retirement without a blind clue what they are getting out of it and they do not have the tools or equipment to make informed choices.”
Although the mantra is that communications must be kept simple, that good intention often shifts to accommodate all the information employers think they need to supply. Mark Bingham, senior partner at adviser Secondsight, says: “Many big consultants work on the assumption members will want to read the big packs of information they send out, but they do not bother to read it because they do not understand why they should. For employers, they send something out they think is useful, but before they know where they are, they are drowning in questions.”
Modelling tools can forecast the impact contribution levels and investments will have on an employee’s pension, but they can be complicated to use and require the member to key in data about other pension plans and financial circumstances. Chris Atkin, managing director at Atkin and Co, says: “Models rely on past data and their scope is limited, so they should be regarded as a guide. The model’s relevance, its shortcomings and statistical imperfections must be understood.”
Preferred retirement age
Members will generally have been asked to give their preferred retirement age, but these are often optimistic, and should be reviewed to prevent a lifestyle fund switching the member into bonds and cash prematurely.
Atkin adds: “The removal of a default pension age also makes the application of conventional models more difficult since the crossover point from net investor to net disinvestor is variable. There may be a move towards income drawdown arrangements in due course, if they can be made to run more efficiently for small funds. If income drawdown becomes the norm, the emphasis switches from capital to income, at least until the fund has been run down significantly, and this alters the shape of the model and the ‘ideal’ investment strategy.”
Whether employees should be encouraged to make active investment decisions depends on each scheme profile, but most advisers suggest trying to keep the fund choices to a minimum and using risk profiling to slot members into an appropriate fund. Behavioural research indicates that if members are given too much choice, they will become confused and reluctant to make any selection.
The default fund is therefore critical, and most advisers recommend a mix of diversified assets to dampen risk without limiting upside, while The Pensions Regulator has stressed the need for proper and continued monitoring. Hamish Wilson, managing director of Hamish Wilson consultancy, says: “Trustees often put in a default fund, leave it for years, then look perplexed when we ask them if they have reviewed it. The strategy should be tweaked so it is appropriate for the times it cannot be fixed once for 40 years.”
If members are surprised or disappointed by the benefits they receive, the employer’s reputation could be at risk, as well as its ability to obtain sufficient goodwill for the cost of offering a pension scheme.
The Pension Regulator’s Guide for Employees is available here
The Investment Governance Group (IGG) and the Confederation of British Industry have published a guide for employers: Looking after your DC plan
A report on responses to the 2010 IGG consultation on investment governance principles can be seen here
Read more on contract-based defined contribution pension schemes