Make sure defined contribution pension default funds are dependable

Most defined contribution scheme members choose the plan’s default fund, so employers should make sure it is not a bad option, says Jenny Keefe

In an episode of The Simpsons, Homer achieves one of his dreams by becoming a Nasa astronaut. It looks like his buddy, Barney, will be the one shot into space, but when he falls off the wagon, Homer is picked by default. “De-fault,” he bellows, “the two sweetest words in the English language.”

While most employees know default is one word, it is not always the best option, especially if they are a member of a contract-based defined contribution (DC) scheme. Since the number of trust-based plans began to decline a decade ago, employers have favoured contract-based plans as a cheap and easy alternative. For these, they do not have to appoint trustees, just an administrator and an adviser. But this can leave many employees languishing in inferior default funds, with no one looking after their interests.

Richard Butcher, director at independent trustee company Pitmans Trustees, says: “Many employers make the mistake of doing nothing with contract-based pensions and leaving it entirely to employees. Then most employees do nothing and it becomes an investment decision void. The funds used are those members fall into [which is] not the best way to choose an investment strategy.”

Set up a committee

Employers should set up a committee to oversee the default fund, in the same way that a trustee board oversees the governance of trust-based schemes. “Employers need to set up a committee with an independent chairman and member representation,” says Butcher. “Staff should get involved, too. Do not skimp on the committee’s operation. There may be a cost, but if done well, it can produce a return on capital.”

So what should a governance committee do? “Its job is to make sure a default fund is appropriate and members shop around for the best annuity,” says Butcher. “It must communicate and ensure they understand risk, what they will get at retirement and the savings gap they need to fill.”

But however well employers communicate investment options, most employees will tick the default box without investigating other choices. According to the National Association of Pension Funds’ Annual Survey published in November 2009, almost 90% of DC plan members opt for the default fund. Jonathan Phillips, director at Bluefin Corporate Consulting, says: “Most employees are reluctant investors. They do not choose to get to grips with the finer aspects of asset allocation, glide paths and volatility. No matter the accompanying education, few will actively manage investments.”

Beware worker inertia

This worker inertia means employers should consider the default fund their scheme offers. “A good default fund should be simple to understand and competitively priced,” says Phillips. “It should not only reduce risk a few years before retirement, but consider the issue of investment risk throughout the term. Ideally, the fund should be flexible enough to accommodate changes in market sentiment.”

It also pays to check the fund regularly, says Mark Jaffray, senior investment consultant at Hymans Robertson. “Several things may trigger the need to change the default option: changes in investment markets, shifts in workforce age profile, new legislation and contribution increases. Default options need to be continually reviewed and governance committees should not shy away from changing the default option, at least for new contributions.”

So how will contract-based scheme governance progress? Pitmans Trustees’ Butcher says: “The regulator is issuing plenty of guidance on how to govern contract-based schemes, and it is not doing this for fun. At some point, someone, somewhere will wave this guidance about and tell their employer it is deficient compared to it.”

Stay in the loop on contract-based pension scheme guidance

Unlike trust-based schemes, there is little regulation to protect contract-based defined contribution (DC) scheme members. This prompted The Pensions Regulator to draw up guidance for employers with contract-based DC schemes. In July 2009, it issued a statement calling for employers with contract-based pensions to work closely with their provider and advisers, as well as set up a governance committee to oversee the scheme. The regulator suggested employers should monitor charges, review investment options, communicate to members and ensure their scheme meets workers’ needs.

Read more articles from Special report 2010: contract-based pensions governance