Starting a defined contribution pension from scratch

If you read nothing else, read this…

• A defined contribution pension scheme is no longer a hands-off option, with The Pensions Regulator turning its spotlight on these plans.

• Good governance is a relatively cost-effective way of differentiating an employer’s pension scheme.

• Employers should give careful thought to default funds, and clarity around the choices when members retire.

• Insufficient savings are a risk for both members and employers, particularly because poorly performing employees can no longer be forced to retire.

Employers that need to create a new DC pension scheme have to make the right choices from the start, says Ceri Jones

Every employer must have a pension scheme in place to comply with the 2012 reforms, which come into effect from next year. Meanwhile, some employers may be looking to reduce the risks associated with their existing pension. In both cases, this may mean setting up a defined contribution (DC) plan from scratch.

When choosing what kind of DC pension to offer, most employers are likely to go for a contract-based, rather than trust-based, scheme because these are generally the easiest and least time-consuming option.

The Pensions Regulator (TPR) has focused on DC plans in recent years, and although its guidance is currently voluntary, the Department for Work and Pensions expects certain standards to be met and will legislate if employers fail to shape up. TPR’s guidance mainly concerns the knowledge and understanding of trustees, conflicts of interest, monitoring the employer covenant, administration, relationships with advisers, and processes for making investment choices.

David Bird, senior consultant at Towers Watson, says: “It will not be long before every employer has a pension, so just having a scheme will no longer differentiate an employer in the marketplace.”

But employers can differentiate themselves by doing more than the minimum. “Differentiation through better governance involves thinking about issues such as timely investment reviews and better default options,” says Bird.

“In the past, employers did not have to take much of a role in contract-based plans, but this has now been flipped on its head.”

Clarity around governance

Clarity around governance is vital, says Hamish Wilson, managing director of actuarial firm Hamish Wilson. “It should be clear exactly who is responsible for reviewing the managers,” he says. “It cannot be the provider because it is going to be biased.”

A good approach to default funds is to provide three lifestyle funds (cautious, balanced and adventurous) plus a further choice of funds for the few employees who are minded to make a selection. These could be actively managed funds if the employer intends to monitor them, or passive funds.

In theory, employers could join forces to gain economies of scale by pooling administration and investments, but few such schemes exist. However, increasing acceptance that a traditional DC structure does not always deliver the best outcome for members may encourage more employers to look at pooled arrangements, which can achieve better returns for staff and are subject to less volatility than standard DC schemes.

It is important to get contribution levels correct at the start, especially following the abolition of the default retirement age. Steve Herbert, head of benefits strategy at Jelf Employee Benefits, says: “The risk for the employer is employees not having sufficient money to retire, because they can no longer be forcibly retired at normal retirement age.”

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So, if employers want to make their DC pension stand out from the crowd, they must make the right choices at the beginning.

Read more on defined contribution pension schemes