Choice between trust-based and contract-based DC

Ceri Jones sizes up the move from a trust-based to contract-based DC pension

When the first wave of final salary pension plans were closed in the early 1990s, many employers switched to trust-based money purchase schemes. As the pensions landscape has changed, sponsors of trust-based pensions may now find that they are looking at contract-based arrangements and envying their relative ease in terms of costs, administration and governance. But making a switch is not as simple and advantageous as it first appears.

A common argument for a contract-based scheme is a reduction in the employer’s administration costs, such as the processing of contributions and day-to-day record keeping. Under a contract-based scheme, these costs, which can amount to upwards of £30,000-£40,000, are passed on to the pension provider. As far as legal and consultancy fees go, these are paid by the sponsor whatever the structure of the arrangement. Another saving, according to Roger Mattingly, director at HSBC Actuaries & Consultants, is the administration required in relation to deferred members, such as annual statements.

In the past, employers may have been worried that a move to a contract-based scheme could undermine their image among staff. However, Craig Rodger, consulting director of Jardine Lloyd Thompson Solutions, says: “Many providers have developed their communications offering and an awful lot of branding is now available so that documents look like they have come from the employer. Interactive member data services have also come a long way. Most life insurer systems, for example, allow members to log in to see how much their fund is worth and offer ‘what if’ scenarios showing the impact of additional contributions or a change in retirement date.”

Another perceived benefit is that the removal of a trust-based structure eradicates issues around governance. The recently introduced Occupational pensions schemes (trustees’ knowledge and understanding) regulations 2006 are daunting and mean trustees must keep ahead of developments in investment. “Many employers are finding costs in terms of time and money are beyond the level they find acceptable,” says Rodger.

However, the Pensions Regulator has just published guidance on Voluntary employer engagement in workplace contract-based pension schemes that covers governance issues. Paul Macro, senior consultant at Watson Wyatt, says: “The idea that an employer can just let a contract-based scheme run itself is going to be a thing of the past. The difficulty is how do you enforce governance of contract-based arrangements and what [enforcement] powers can the regulator have?”Perhaps the biggest hindrance to making the switch is the actual process of winding up a trust-based scheme. It is a huge administrative task, which involves writing to each member and buying them out with a section 32 plan. The business of locating the deferred members can be onerous, depending on the quality of the scheme data. “The costs of wind-up could be £20,000-£30,000 and could go north of that depending on the state of the administrative data. It could also run into two or three years,” says Macro.

While a scheme remains trust-based, the employer is liable for any shortfall in the event of default by the life office paying the pensioners’ annuities. Buying out each member eradicates that liability for the sponsor, throwing members on policy protection cover should the provider fail. It would be wrong, however, to imagine that a life insurance provider could never go under; indeed, even now, the Financial Services Authority is reviewing life firms amid concern that many have mounting historical annuity liabilities.

Furthermore, a switch to a contract-based scheme makes it difficult for the sponsoring employer to access any trapped surplus that may have been built up under a trust-based final salary arrangement. Currently, schemes with such a surplus must use it to increase members’ benefits up to the maximum allowable by HM Revenue & Customs but the government is looking to weaken this rule.

There is also the thorny issue of investment. With a contract-based plan the member makes choices from among the funds available. The biggest impact will be the increased charges on investment funds. The range of funds available has improved over the years and most insurers now offer access to guest managers as well as their own in-house funds. However, as money purchase pension pots get larger, there is a risk an employee could bring a legal case against their employer for allegedly offering an inappropriate or poor investment. But cynical employers may take the view that if a contract-based scheme is in place, the provider will be first in the firing line, as the issuer of the investment materials.

Finally, it is worth employers looking at the tax positions of staff, which vary according to the type of scheme they are members of.