Special report: Defined contribution pensions

Executive Summary:

• Employees need to be educated about the importance of investments in contract-based DC plans.

• The introduction of auto-enrolment in 2012 will increase take up of pension schemes to around 80% or 90%. This means that pension costs could jump dramatically for most employers.

• Planning for personal accounts should now be underway. Employers need to either to ensure their current pension schemes meet the criteria to exempt them from offering personal accounts, otherwise they will need to offer personal accounts.

• It is vital to offer a good default fund because almost all employees will select this option. If the default fund doesn’t produce what members expect, they may demand that the employer redresses this so FDs could face having to put more money into pensions if employees cannot afford to retire.

• Offering staff a contract-based DC pension still means that employers have a duty of care to ensure that the plan and its investments will produce a decent pension. Employers could improve governance with a management committee, which could keep an eye on the DC plan’s investment performance and ensure that the scheme keeps up with market developments.

Main article:

Setting up a contract-based defined contribution (DC)†pension scheme has been a popular move for some time with many employers. By using a group personal pension (GPP)†or stakeholder pension from an insurance company, employers have been able to control pension costs and reduce the amount of management time spent running a pension scheme.

But contract-based DC pensions do not mean that an employer has shed all of its pensions obligations; ultimately, staff will come back to their employer if there are problems with a scheme offered in the workplace. It makes sense for an employer to monitor the running of a contract-based DC pension, as there are a range of issues which could have cost implications for a finance director.

One such issue is the investment performance of the DC pension, as this will have a direct impact on members’ living standards in retirement. It is also very topical; millions of people have seen their pension funds slashed in value as a result of recent market falls.

An obvious action for employers is to review the investment funds offered, particularly the default fund for members who do not make an active choice on where to invest. Paul Macro, senior DC consultant at Watson Wyatt, comments: “Stakeholder pensions have to have default funds and the vast majority of GPPs now have default funds. 90% of members end up in the default fund, which means the selection of it is pretty important.”

Most default funds offered by contract-based DC plans invest heavily in equities for younger members and gradually move assets into safer investments, typically cash and bonds, as members approach their expected retirement age. Given the recent equity market volatility, lifestyle default funds should have protected members approaching retirement from a disastrous fall in their pension fund in the run-up to retirement.

Mercer principal Roger Breeden says: “Having a five or 10 year cycle for disinvesting from equities is a discussion point at the moment. People currently half-way through a five year switch out of equities are selling equities at quite a low level, but selling over a period of time will take some of the heat out of this.”

The suitability of equities as the investment for younger members could be under scrutiny too. Most investment experts believe equities will produce the best long-term returns, but there could be long periods of relatively flat performance. Macro comments: “The FTSE 100 is now at the level it was five years ago, so over the last five years people have not made anything.”

Over in trust-based pension plans, where trustees monitor investment matters, there is growing interest in the use of diversified growth funds, or multi-asset funds, which aim to provide similar long-term returns to equities, but with less volatility. This may give a more appealing risk-return profile to DC members for default funds and, in time, contract-based schemes could start to offer this type of fund. Some experts believe offering a single default fund to all members, regardless of their age and risk preferences, means that it will be unsuitable for some. One option here is to tailor default funds to a scheme membership profile or to groups within it.

Jardine Lloyd Thompson Benefit Solutions consulting director Craig Rodger says that a few years ago most default funds were based on with-profits funds offered by insurers. “Then, because stakeholder pensions didn’t fit into the terms of with-profits funds, insurance company managed funds were used for default funds. Then insurance companies started to blend funds together to make more efficient default funds, and now advisers are looking to blend funds together to take ownership of what’s happening in the default fund area,” Rodger says.

Whatever type of default fund is offered, FDs should be aware of its importance. Macro says: “If the fund doesn’t produce what members expect, someone is going to come back to the employer and say ‘this hasn’t delivered, what are you going to do about it?’.”

As a result, FDs could face having to put more money into pensions if employees cannot afford to retire. Macro warns: “FDs can’t forget about default funds because they could come back to haunt them.”

The importance of investment in contract-based DC plans is something that should be supported by pension communications and work done to educate members. The current investment climate will have reached water-cooler conversations, so a little reassurance from the pension scheme could go a long way with its members. For example, older members could be reminded of the protection they get from a lifestyle strategy which moves them away from equities. Breeden pointed out: “No-one really knows what is going to happen with the markets in the short-term, but in terms of communication, employers should make sure staff know what they have and how it should work, so people can understand and plan for themselves.”

Making an effort to communicate regularly and in a fresh and stimulating manner should also impress The Pensions Regulator (TPR), which has been taking an interest in contract-based pensions. In November 2007 the TPR and the Financial Services Authority (FSA) published a joint guide on DC regulation and the TPR followed this in January with guidance on voluntary employer engagement in GPPs. So far, the regulator has promoted what it sees as best practice, rather than legally binding standards. One possible source of tension here is that, as Maclay Murray & Spens partner and head of pensions practice Gary Cullen points out, minimal governance requirements are one attraction of contract-based DC pensions.

Cullen comments: “All the employer has to do is to pay limited contributions and keep records. The plan is mainly a matter between employees and an insurance company and it is not overly onerous for the FD.”

But JLT Benefit Solutions’ Rodger feels that employers have a moral obligation towards staff regarding their pensions, even if the only actual regulations for contract-based DC schemes are limited to the stakeholder pension rules. “Employers should not abandon the principles of governance. They could improve governance with a management committee, which might be for benefits, not just pensions”, Rodger adds. A management committee could keep an eye on the DC plan’s investment performance and ensure that the scheme keeps up with market developments.

Breeden says the size of an employer and its resources could influence its governance arrangements. “You have to have a flexible approach; organisations should look at what would be reasonably expected of them, given their size. Employers should also be clear about what they are and are not going to do.”

Another issue is the attitude of the insurance companies that run most contracted-based DC plans. Breeden says: “The insurance companies are improving their management information to support governance, helping employers understand what’s going on in their plans.” This sort of management information could cover which funds are being used, switching activity, average account balances and other areas.

Views differ on how far The Pensions Regulator will go in policing contract-based DC schemes. “Contract-based DC plans are not the top priority for TPR. TPR is the guardian of the Pension Protection Fund, which looks after final salary schemes, and it is not overly concerned with what is happening in the money purchase world.”

However, Breeden noted that disaffected DC members in the USA and Canada have taken action against their employers. “We find that US clients are much more receptive to governance as an issue, as they are more likely to suffer from class actions in the States over 401(k) plans. They are saying ‘are we at risk from disaffected employees or former employees?’.”

Some employers may be keener than others on the idea of governance, but all employers are equal when it comes to personal accounts, which will fundamentally alter the pensions playing field from 2012. This date is little more than three years away, so FDs should already be thinking about the impact of personal accounts.

The introduction of auto-enrolment is seen as the most significant change. Macro comments: “Take-up of DC is around 50% of employees. In 2012, we are likely to see an increase to 80% or 90% take-up.”

For FDs, this means that pension costs could jump dramatically. Macro says some employers will introduce auto-enrolment before they have to, in order to get some brownie points. Rodger warns: “FDs need to be aware of what’s happening with personal accounts and if existing staff are going to be exempt. They need to think about their remuneration strategy and phasing in contributions to personal accounts.”

Rodger also says he was sceptical on the impact of personal accounts until some issues had been resolved, principally its interaction with means-tested benefits. “Until a pound in a pension means that someone is a pound better off in retirement, the impact of personal accounts will be watered down, as it won’t necessarily mean more money for low earners”, Rodger says.

Breeden adds that personal accounts should trigger thinking on benefits as a whole, not just pensions, and where resources should be allocated. Auto-enrolment could also replace efforts made to get new employees to start a pension, so employers can concentrate more on members who are 10 to 15 years from retiring.

Many contract-based DC schemes have been set up with the help of salary sacrifice, which gives employers a saving in National Insurance. In the past there have been concerns that the government could close the loophole allowing salary sacrifice, but many have been reassured by HM Revenue & Customs issuing guidelines on the use of salary sacrifice. Macro says: “Salary sacrifice is now seen as being within the rules and we and most of our clients are much more comfortable about putting it in place. Unless you have a low-paid group of employees, there are no obvious reasons why you would not use salary sacrifice.”

Contract-based DC pension plans may have originally been sold to employers as a cheap and simple alternative to occupational schemes, but there are still issues for FDs to consider. Planning for personal accounts should now be underway and questions may need to be asked about investment performance, particularly if most members are in a default fund. The old saying, that an ounce of prevention is worth a pound of cure, seems particularly apt here. A management committee to oversee a contract-based DC plan may not have been in the original specification, but it could be a worthwhile venture.

Contract-based DC pensions and Tupe:

Maclay Murray & Spens partner and head of pensions practice Gary Cullen says that under a quirk of the Transfer of Undertakings (Protection of Employee), or TUPE, rules, the presence of a group personal pension (GPP) or stakeholder plan can mean extra expenses for the buyer, when a pension is transferred in the sale of a business.
“If you sell on a business under Tupe, the full extent of the pension contribution being paid passes to the buyer,” Cullen says. At one employer, the old defined benefit (DB) scheme was closed, with a new GPP set up. To compensate for the loss of DB membership, the employer paid contributions into the GPP at up to 30% of salary. Under TUPE rules, a buyer of the business would have been obliged to match the old DB contributions up to 6% of salary, as it was an occupational pension scheme. However, this limit does not apply to GPPs and stakeholder plans, where a buyer has to match the full amount of the seller’s pension contribution.
“The buyer was not very pleased that a few months before the transaction the seller had moved from an occupational pension scheme to a GPP. This is one scenario where you could be worse off with a contract-based DC plan,” Cullen notes.

Back to Employee Benefits Report for Financial Directors – November 2008