An A-Z of DC

July/August 2010

A is for ANNUITY

An annuity is a contract between an individual and an insurance company where the saver receives regular payouts for the rest of their life in exchange for a lump-sum payment. Previously, retirees had to convert the balance of their pension pot into an annuity at the age of 75, although the government has said it intends to scrap this rule.

B is for BENEFITS

Benefits are the payments made out of the pension pot at retirement. This usually takes the form of a tax free lump sum of up to 25% of the size of the pension pot, with the remainder converted into an annuity.

C is for CONTRACT-BASED SCHEMES

Unlike trust-based DC schemes, which are overseen by trustees, contract-based pension schemes are outsourced to a third party – often an insurance company – which manages all aspects of the scheme. While contract-based schemes do not have trustee boards, employers are increasingly setting up in-house governance boards to monitor the performance and other aspects of contract schemes.

D is for DEFAULT FUNDS

Default funds are the ‘standard’ investment option for DC schemes. Figures from the National

Association of Pension Funds show over 80% of DC scheme members end up in the default option, meaning the design is very important. Despite this, many default funds are heavily weighted to risky assets such as equities, which may not be a suitable investment for all members.

E is for EMPLOYER CONTRIBUTION

An employer contribution is the money paid into the individual saver’s pension pot by the employer. According to the Office for National Statistics, the average employer contribution in 2008 was 6.1%, against 16.6% for defined benefit schemes. Although employers are not yet required by law to pay contributions, this is set to change around 2012 (see ‘T is for Twenty Twelve Reforms, below), when a minimum of 3% will be phased in, via auto-enrolment.

F is for FUND RANGE

Aside from the default fund, a DC scheme will typically offer a range of other investment options or funds with a varying degree of investment risk. These are often named funds from an asset manager (such as XYZ’s global bond fund). In other instances employers are able to build their own ‘white-labelled’ funds that are offered to employees under the employer’s own name and branding.

G is for GOVERNANCE

Good governance for DC should minimise risk while maximising the value of each saver’s pot and is essential for the smooth operation of a DC scheme. Trustees need to make sure records are accurate, which ensures all contributions are correctly logged, and make sure the default fund is suitable for the majority of scheme members. By outsourcing the administration or fund management side of DC provision, trustees may be able to concentrate on more strategic activities. But getting governance right first time is vital, as mistakes can be very costly to rectify afterwards.

H is for HIGH EARNERS

Some DC schemes may not be felt to be suitable for higher earning employees. Employers are looking at a variety of alternatives for their higher earners, such as EFRBS (Employer Funded Retirement Benefit Schemes) or foregoing pension contributions and offering salary top-ups instead. Other alternatives include corporate SIPPs (Self-Invested Pension Plans).

I is for INVESTMENT GOVERNANCE GROUP

The Investment Governance Group, or IGG, is an industry body which aims to improve governance among DC schemes, by making the so-called ‘Myner’s Principles’ on investment decisions applicable to DC. The IGG issued a consultation paper on this issue earlier in the year, which sets out ideas on trustees’ duties on accountability, transparency and fund governance. It also sets out principles for investment decision making, a best practice guide and a checklist for responsibilities at each step in the process.

J is for JOINERS

While trustees and scheme advisers cannot force people to sign up to a pension scheme, most people would argue that saving for retirement is important. There will be some employees – notably the younger members of the workforce, paying off student loans or other debts – who may feel that joining the scheme is not suitable. Although trustees cannot give financial advice, they can point new joiners in the direction of financial advisers who can help them make a decision.

K is for KNOWING YOUR MEMBERS

Accurate data and administration is vital in DC schemes. As pension income is entirely dependent on the balance a member’s pot at retirement, any mistakes or errors may be both costly to rectify and could have a severe impact on the overall value of the pension. Trustees and administrators are also well placed to know about changes of address or other alterations. Trustees should also ensure the range of investment funds is suited to the needs of the membership. Understanding the make-up of your membership is also a crucial element of good quality communications.

L is for LIABILITY

Like their defined benefit (DB) scheme peers, trustees of DC schemes have a legal liability, although the risks are different. DC trustees are responsible for making sure member statements and the valuations of investments are accurate, which places an extra burden on them since the member carries all of the investment risk. Similarly, DC scheme trustees are also responsible for selecting and monitoring the underlying assets in funds. Given the number of members who will invest in the default fund, trustees have a responsibility to make sure it is suitable for members and take steps to ensure they are protected against any allegations of mis-selling.

M is for MULTI-EMPLOYER FUNDS or MASTER TRUST

Multi-employer funds and master trusts are trust-based vehicles which pool investments from several employers in order to benefit from greater buying power and generate savings.

N is for NEST

The National Employment Savings Trust, or NEST, is the Government’s flagship pensions savings fund for low earners. It has been designed as a low cost, easy to use, online pension scheme that is open to any employer and is due to launch for larger employers in 2012, before being made available to all companies by 2016. Contributions will start at 3% – 1% each for employer and employee with 1% tax relief, before rising to a minimum of 8%, with a 3% employer contribution and the rest coming from the employee and tax relief. The scheme will be overseen by a board of trustees drawn from the pensions industry.

O is for OPEN MARKET OPTION

The Open Market Option, or OMO, allows scheme members to shop around for annuity providers when retiring, in order to get the best available annuity rate. Some estimates show this could improve annuity rates by up to 30%. Members should consider choices such as ‘Enhanced’ annuities that offer higher annuity rates for savers with poor lifestyles – such as smokers – who are statistically likely to die earlier than ‘healthy’ savers.

P is for POLITICS

For many years, pensions have been a political football, and this does not look set to change any time soon, with independent commissions in place to assess the default retirement age and state retirement age, as well as public sector pensions. The results may ultimately see greater use of DC schemes in the public sector.

Q is for QUALITY MARK (NAPF)

The National Association of Pension Fund’s Quality Mark is an initiative to recognise high quality DC schemes. To qualify, schemes have to offer contributions of at least 10%, of which 6% must be an employer contribution; have strong governance structures in place; and provide clear and simple communication with members. Schemes which have been awarded the Quality Mark include Marks & Spencer and Kellogg’s.

R is for RISK SHARING

In a standard DC scheme, all of the investment the risk is carried by the saver – meaning if markets fall, the individual member is hit. ‘Collective DC’ proposals would allow schemes to share risk by pooling investments between all members of the scheme, smoothing out investment losses and reducing costs through the greater buying power that pooled investments can bring. At present, ‘collective DC’ remains a proposal only, due to legislative barriers.

S is for SIZE

Many DC scheme members have found that they have low balances at retirement, meaning they will be less likely to buy an annuity that can serve as their sole source of retirement income. This is partly because members close to retirement are more likely to have been members of now-closed DB schemes and so not had a long time to build up a decent DC balance. Despite this, services do exist which can help savers with small pots find better annuity deals.

T is for TWENTY TWELVE REFORMS

From around 2012, it is proposed that schemes will be obliged to auto-enrol members into the pension plan, with an option for savers to opt out. It is expected that auto-enrolment will lead to far greater participation in pension schemes – although the entire auto-enrolment reform is currently being reviewed by the coalition government. Trustees and HR departments need to be aware of the extra administration and work this will require. The 2012 reforms will also introduce NEST and force firms which do not offer an employer contribution to do so.

U is for UBIQUITY

In the coming years, DC schemes are set to become ubiquitous, taking over from DB as the most common form of retirement saving. A recent survey by consultants PricewaterhouseCoopers found 94% of employers intended to freeze or close their DB schemes in coming years, while the vast majority of new scheme members only have the option of joining DC arrangements.

V is for VOLATILITY

As the events of the past couple of years have shown, markets and investments are volatile – they can go down as well as up. For savers approaching retirement, it is important to strip out as much of the volatility in the DC pension pot as possible by moving out of volatile and risky assets such as equities, into less risky assets such as bonds, in order to protect the saved balance. The reverse is true for younger savers, who can take more risk in their investment portfolios, as they have the time to recover any losses. This approach is known as life-styling.

W is for WORKPLACE SAVINGS

Pensions are not the only form of workplace saving. In recent years, alternatives such as workplace ISAs (independent savings accounts) have been put forward as possible new methods of encouraging employees to save for the future. One advantage of offering non-pensions based saving is that members will be able to use the accounts for other lifetime saving needs, such as buying a house or funding a child’s university tuition fees. There has even been a proposal to include workplace ISAs as part of the proposed auto-enrolment regime.

X is for EXPLANATIONS

With something as complex and life-changing as investing in a pension, it is vital members are given as much information as possible before making decisions, and continue to have access to information about contribution levels and fund choices. Trustees and financial advisers need to be able to explain to members the effects of their decisions. Members also need regular statements about their pension pot and regular communication on the performance of their investments.

Y is for WHY NOT REOPEN THE DB SCHEME?

Although it is highly unlikely, companies could always reopen their closed or frozen defined benefit scheme, or replace their existing DC arrangements with something closer to a DB scheme. Hybrid schemes, which offer a combination of DC and DB elements, are one option, while the National Association of Pension Funds has proposed a ‘no-frills’ DB structure which would radically reduce costs for employers. A typical hybrid scheme may offer employees a DC scheme until a certain age – 40, for example – before converting to a more traditional DB structure. Other hybrid structures offer DB accrual on salary up to a certain point, with the remainder used on a DC basis.

Z is for ZIMBABWE

It may be a beautiful country, but nobody wants inflation to rise to Zimbabwean levels – especially DC trustees and members, as DC funds are not usually inflation-linked. Therefore, sharp rises in inflation will wear away the value of savings, meaning retirees will be considerably worse off at retirement. Trustees should think about adding inflation-linked assets as an option in members’ investment funds.