Guidance issued by the Pensions Regulator on Voluntary employer engagement in workplace contract-based defined contribution (DC) pension schemes in January has thrown the spotlight on best practice for defined contribution (DC) plans. While there is no obligation to follow the regulator's guidance - and indeed many employers have chosen DC schemes precisely to rid themselves of regulatory burden - pensions are an expensive benefit that most employers like to own. There is also increasing awareness that some of the issues raised by the regulator, such as member communication and the need to review provider costs and funds, carry some risk if ignored.
Nick Cook, senior DC consultant at Watson Wyatt, says: "The challenge is member understanding. Education is the biggest risk, so there is now greater focus on this whole area of employee engagement, whereas, in decades past, running a pension was seen more as an issue of implementation and operation."
Investment, for example, is open to much misinterpretation. Some providers have used their open architecture to offer a huge array of choice, for example, 100 fund options, possibly including five or six UK equity funds, is common. However, offering too great a choice tends to confuse members and can result in a greater percentage choosing to play it safe by opting for the default fund, which will not always be in their best interests. "Employers are now increasingly looking at tailored approaches and restricting the range of appropriate funds," adds Cook.
Between four and nine funds seems to be the general recommendation, with a note included in a scheme's literature setting out that an extended range of funds is available if wanted. This can direct members to a website where detailed information on a wider range is posted.
One of the most difficult issues is how to convey funds' various risk profiles and investment strategies accurately, particularly the concept that equities are generally a better choice for members who have a long time left until they retire. Some consultants tackle the issue by looking at the length of time left until a member's retirement and what option will, therefore, be most appropriate for them rather than emphasising the risks attached to different types of investment, which could send cautious members scurrying into cash even if that will penalise them over the long term. Face-to-face presentations are typically thought to be the most effective medium for conveying the central investment concepts.
Another concern is that employees can be interested in their pension when they first join the scheme, and make specific fund choices, and then subsequently lose interest in active switching, leaving their money in a sector that goes on to tumble or stagnate.
One solution for employers, as part of their governance structure, is to regularly review the scheme's demographic data, exploring the investment choices that have been made. Providers are well placed to supply information on the scheme and how different age bands are investing. Communications programmes can then be tailored using this data.
Most employers will choose a lifestyle fund as the default option, which will automatically switch employees out of equities and into safer investments, such as bonds and cash, as they approach retirement. This is not a perfect solution as some members may wish to retire early, while others may want or need to delay retirement and the comfortably-off may not want to limit their potential returns in this way at all. One approach to the traditional lifestyle default is to survey staff on issues such as when they plan to retire, which might at least help identify those who are able to choose when they retire.
Another option is to use diversified growth funds, which claim to be able to use a mix of assets to offer the same potential returns as equities with reduced volatility. However, the jury is still out on the performance of this relatively new style of investing.
If selecting the best funds throughout the course of a member's working life is not something even the most skilled financial experts can achieve, then choosing the best annuity at retirement is a straightforward decision, but one with which members will need help. Annuity rates not only vary massively from provider to provider for the same terms, but some providers offer enhanced terms if the annuitant has certain health conditions, smokes, or even lives in a postcode associated with high mortality. The increasing complexity of this market highlights the need for pre-retirement counselling.
Nigel Callaghan, pensions analyst at IFA firm Hargreaves Lansdown, says, for example, that a 65-year-old male will, on average, be able to exchange a £50,000 pension pot for an annual income of £3,719, but if he smokes more than ten cigarettes a day that figure rises to £4,447. Legal & General, meanwhile, is rolling out a postcode-based system offering better rates for those who live in areas where life expectancy is lowest. These are not areas that one might expect, like Glasgow and Belfast, but relatively surprising locations such as Nottingham and Islington in London.
A central part of the regulator's guidance focuses on establishing governance committees. There is a split in opinion in the industry, however, about whether to rope in trustees already acting for any legacy defined benefit scheme. While they will be well placed to understand the issues, the cumbersome framework of a big committee could be seen as re-inventing some of the burden of trust-based schemes. Others believe a committee might consist of no more than the HR director and the managing director of a small firm, or the finance director in a larger organisation.
However, consultants on the whole believe that employers need to put in place measures in order to protect themselves, so that if at some point in the future employees who have built up quite substantial funds, see the value of these decimated by some sort of market collapse, perhaps believe their employer should have warned them this could happen.
Helen Dowsey, DC principal at Aon Consulting, adds: "There's an assumption on employees' part that the employer is monitoring it, but employers often think the provider is monitoring it. For example, the employer might think the provider is keeping tabs on fund manager movements and will inform the employer if an important manager leaves, but the provider's response might simply be not to market that fund to new clients, rather than alerting existing clients."
What is practical will depend on the size of the scheme. In fact around half of the DC schemes surveyed by the regulator already have governance plans in place. "In a way, the investment in a scheme, the financial commitment and the administration costs already show the employer's commitment to the scheme," says Dowsey.
The regulator's guidance, however, does little to deal with the problem of employees being faced with information overload. John Foster, DC consultant at Hewitt Associates, says it is useful but "the proverbial rainforest of literature from the Financial Services Authority to protect against mis-selling is now so voluminous at the point of sale that it doesn't help in keeping messages clear.
"A member in a stakeholder pension, for instance, will receive a decision-tree and key features document [so] dozens of pages of information will land on their doorstep obscuring the [employer's] message."
Pensions Regulator's guidance
• The regulator's guidance on Voluntary employer engagement in workplace contract-based pension schemes was published at the end of January 2008 and discusses the types of activity an employer may like to consider for review.
• A central plank of the guidance is the establishment of governance committees to support difficult areas such as member communications, and provider and fund monitoring.
• While the guidance does not place any additional obligations on employers, it recommends that they should determine which form of governance, if any, best suits their occupational pension scheme.
• Voluntary governance arrangements can help employers mitigate the risks associated with contract-based defined contribution pension schemes.
Case study: Eurotunnel
Eurotunnel established a governance committee for the defined contribution (DC) scheme it opened in October 2006 which replaced its final salary scheme. Its terms of reference include responsibility for monitoring the pension provider and the range of funds, identifying member risks, reviewing member communications and death-in-service nominations, and ensuring the plan is administered within service level agreements.
The committee consists of three or four individuals from different parts of the business who have been appointed by the firm, including a representative of the staff company council and a representative of union Unite, with which the company has a partnership agreement. The committee meets two-to-three times a year and members are entitled to time off work to attend its meetings and to other duties. There is a possibility of including member-nominated staff in the future, according to consultancy Watson Wyatt.
Terry Robinson, director of human resources at Eurotunnel, who is also chair of the committee, says: "The committee meets to ensure the scheme is well run, to monitor the performance of the investment manager, Standard Life, and to review usage of the scheme. A key issue is member communication through which staff are continually encouraged to contribute as much as they can afford thus benefiting from matched employer contributions. As members approach retirement the issues of types of investment, in particular, the alternatives to the lifestyle option, and annuity options will be addressed." The firm also has a process akin to dispute resolution procedures to tackle complaints informally at an early stage and promote open dialogue.