Buyer’s guide to contract-based defined contribution pensions

Focus on facts

What is a contract-based DC pension?
Contract-based defined contribution (DC) schemes are based on contributions from employers and staff. Unlike defined benefit (DB) pensions, DC scheme benefits correlate to the investment fund built up over an employee’s working life, which is typically used to buy an annuity at retirement. These schemes include group personal pension (GPPs), stakeholder schemes or group self-invested personal pensions (Sipps). The relationship is between the individual member and the pension provider

What are the origins of contract-based DC pensions?
GPPs were introduced in 1988 when the government replaced retirement annuity plans with personal pensions. Stakeholder pensions were introduced in April 2001 for employees on low incomes, and have been successful in driving down charges.

Where can employers get more information and advice on contract based DC pensions?

Nuts and bolts

What are the costs involved?
Contract-based DC plans are individually priced, according to the number and salaries of members and staff turnover. An annual management charge of typically between 0.4% and 0.7% is applied to members’ funds, depending on the funds selected. Charges can also be levied when members switch funds. Auto-enrolment is being phased in with large employers, and contributions will rise incrementally. In January, the government revised its schedule of staging dates for employers of different sizes, so full employer contributions of 3% of banded earnings will not have to be paid until October 2018. The increase in the initial 1% rate to 2% has been delayed until October 2017.

What are the legal implications?
Employers must prepare for the 2012 reforms, a process advisers estimate will take 18 months. Key issues include setting up compliant schemes and ensuring systems exist to deal with administration and communications.

What are the tax issues?
Tax breaks are available to both employer and employee, but limited to £50,000 for employees earning over £150,000 a year.

In practice

What is the annual spend on contract-based DC schemes?
According to the ABI, at the end of 2010, new premiums totalled £2 billion for GPPs and £513 million for stakeholder plans.

Which providers have the biggest market share?
Major players include Aegon, Aviva, Fidelity, Friends Life, HSBC, Legal and General, MetLife, Prudential, Scottish Widows, Standard Life and Zurich Life.

Which saw the biggest increase in market share in the past year?
This is unknown, but those paying commission, such as Aegon and Scottish Life, are understood to be gathering proportionately more business.

This year’s pension reforms will accelerate the continuing migration from defined benefit to defined contribution schemes, creating many challenges for employers, explains Ceri Jones

Defined contribution (DC) schemes are not actually the pension of choice in the modern world, they are simply the most affordable model on offer. They are about to become the mainstay retirement vehicle for employees as they replace the defined benefit (DB) world, where people’s increasing longevity has resulted in a far bigger funding burden for employers than anyone could have predicted.

There are three types of contract-based DC pension: group personal pension (GPPs), stakeholder schemes and self-invested personal pensions (Sipps). GPPs and stakeholder schemes are similar in form. They are aimed at the majority of an organisation’s workforce, offering a limited range of investment funds for scheme providers to track on their behalf. The major difference between them is a cap on the annual management fees linked to stakeholder plans, which are aimed at staff on low incomes.

Sipps are essentially DC schemes offering greater investment choice. In addition to the equities and bonds on offer with a GPP or stakeholder plan, Sipps offer wider asset choice, including commercial property. The plans are typically targeted at higher-earning senior managers.

Contract-based DC arrangements involve a contract between scheme members and the insurance provider offering the plan.

One issue currently impacting this market is the government pension reforms, which will be phased in from October this year, starting with large employers, which will be required to offer a pension scheme to all eligible staff – those aged between 22 and the state pension age and earning above the income tax personal allowance.

Employers must automatically enrol these workers into a scheme and pay contributions on their behalf.

Payroll procedures confusion

But there is still some confusion over payroll procedures, and it is feared this could be a major headache for employers. David Barker, a principal at Mercer, says: “Say payday is the 26th [day of the month] and the cut-off for payroll is the 16th. In that period, an employee who becomes an eligible jobholder must be auto-enrolled, which means contributions must go across and communications material sent out.

“But, within one month, they can opt out and refunds would have to be dealt with. Potentially, the payroll flow stuff is a nightmare, and most employers do not appreciate the scale of the issue. They need to sit down and work out a project plan now, or they will run out of time to do it efficiently and without frustration.”

The reforms will eventually require all employers to monitor the eligibility of employees’ for auto-enrolment, because eligibility may change when, for example, employees’ salaries change. These records must be kept for six years.

Employers with established pensions provision must consider whether to expand their current schemes to all eligible staff, and whether their provider will allow this. There is concern that some providers may reject this extra business because of the administrative cost of managing schemes for low-income investors. In such cases, employers are likely to use the national employment savings trust (Nest), or an alternative designed for low earners.

The minimum contribution payable into auto-enrolled plans is due to rise incrementally until 2018. But a number of pension consultants suggest certain providers are reserving the right to increase their charges to offset the extra labour and costs involved in auto-enrolment, regardless of fund size. Steve Herbert, head of benefits strategy at Jelf Employee Benefits, says he has been unable to get a quote from a decent insurer for “a solid little scheme with several millions in assets” because of the high turnover of staff throughout the organisation.

Jamie Jenkins, head of corporate strategy and propositions at Standard Life, expects this problem to occur in several market sectors. “Some employers have significantly diverse workforces, such as retailers, where between 20% and 30% may be office-based, but thousands may work in retail outlets.”

New market entrants include The People’s Pension, run by construction industry pension provider B&CE, and Now: Pensions, an arm of Dutch company APT. Such providers are vying with Nest for mass-market business, but there are doubts about whether there is enough profitable market share up for grabs.

Thin margins for providers

Dominic Fryer, head of strategy and risk for corporate benefits at Friends Life, says: “Some providers are targeting small employers, but across the marketplace, a lot of providers’ margins are very thin. No firms are making substantial returns, so it is hard to see how the newcomers can come and do it profitably.”

The potential explosion in DC take-up under the reforms has prompted The Pensions Regulator to be proactive about DC governance and it has issued various guidance, such as its paper on six principles of good workplace DC.
Most providers are working to develop ‘middleware’ hubs to help employers identify which employees to auto-enrol and when to re-enrol them. The quality of these is seen as a big differentiator between providers. Payroll system providers have been surprisingly slow to task.

Other challenges include addressing scheme members’ failure to build sufficient savings for their retirement. Phased increases in members’ contributions, agreed with the member, are one way to tackle future fund deficits that can be built into a DC scheme.

To develop a default fund with wide appeal, providers have been launching diversified growth and diversified beta funds that aim to smooth returns by investing in a range of relatively uncorrelated assets, such as property.

The retail distribution review (RDR), which takes effect on 1 January 2013, sets another challenge for employers.

This prohibits payment of commission to advisers in favour of a fee agreed in advance. But commission can still be paid on new investments into existing business, which leads Tom McPhail, head of pensions research at Hargreaves Lansdown, to warn: “Even after RDR takes effect, there will still be scope for advisers to take churning fees out of members’ contributions, because the employer is making the buying decision.”

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