The Prologue

Once the Cinderella of the occupational pensions world, defined contribution (DC) schemes are now no longer the bit-part player to defined benefit’s (DB) romantic lead. DC is now the fastest developing form of workplace pension and with that increased focus comes higher profile governance responsibilities for trustees – who need to learn their lines fast.

“The whole pensions industry has been encouraging trustees to ‘think DC’ in terms of governance,” says Lorraine Harper head of pension scheme management consulting at Hewitt Associates. “At the highest level that means thinking about administration solutions, risk to members and investment strategies.”

Whether you are exclusively responsible for a DC scheme, or have joint responsibility for a defined benefit (DB) scheme and a DC scheme – generally termed a ‘hybrid’ arrangement – those points of focus remain the same.

Act I: Savings and benefits

Scene I: The contribution rate

“The biggest impact on member benefits comes from contribution rates and fund choices,” says Brian Henderson principal in the DC consulting team at Mercer. “Contribution adequacy is not discussed enough by trustees.”

Contribution adequacy refers to whether or not the contributions being made into the member’s pension will buy them a sufficiently large annuity to fund a comfortable retirement. It covers both the percentage of salary contribution made by the employee, and also that made by the employer. The structure of the scheme will generally determine how those two interlink – in some instances the employer will contribute a fixed amount and the employee can choose the level of their contribution. In others, the employer commits to matching the employee’s contribution, up to a certain level. For example, if the employee commits to contributing 8 per cent, the employer will match it with a further 8 per cent. Not all sponsors offer to match employee contributions, but many do – and it’s an important part of a good-quality scheme.

Establishing an appropriate contribution rate, and the division between the sponsor’s payment and the member’s payment, is critical to other parts of scheme design such as the fund range, so ensuring that employers and employees are contributing appropriately, and understand the importance of doing so is vital to good scheme governance. Richard Warne, global strategy director, institutional at Aviva Investors says: “Because there is no employer covenant, there is a higher dependence on the trustees to get the investment strategy right, and that includes the contribution rates as well as the fund choices.”

Decisions on the contribution rate will be scheme-specific and need to take into account both the willingness of members to contribute and employers’ willingness to match that contribution. Trustees also need to make sure that employees are aware of the employer contribution – and encourage members to take it up.

That is more difficult than it might appear. “Getting members to take up matching contributions is a big challenge,” says Emma Douglas, head of DC sales at BlackRock. “It might keep the finance director happy in the short term if members don’t take up that extra money, but it’s not good practice in the long run for members.” Not taking up the employer contribution could mean the difference between a good pension at the end of a member’s working life and a very poor one. Consider the difference that a pension of 8 per cent member-only contribution would buy, and that of a 16 per cent member-plus-employer contributions. “It requires some tough messages and the need to communicate reality,” says Douglas.

Scene II: the fund range

The majority of DC schemes offer members a default fund – into which their pension contributions will be invested unless they actively choose an alternative. And typically 80 per cent or more of a scheme’s members will invest into that default fund. That makes good design of the default fund essential. However, until relatively recent times, little attention has been paid to how members’ investments have been handled. A regular read through the money pages of daily newspapers will reveal horror stories of members with funds invested in 100 per cent equities until a few years before retirement – with the inevitable result that their savings collapsed as the stock market fell in 2008.

“The big decision to make with the default fund is about asset allocation,” says Douglas of BlackRock. “Limiting volatility (ie the amount that a fund’s value fluctuates) is very important. Managers need to be able to generate returns that are above inflation, because members don’t want to lose money.”

To address that problem, Diversified Growth Funds (DGFs) are beginning to attract a lot of interest as default funds. These typically invest in a variety of different asset types but change the percentage of each asset in the fund over time to reflect market conditions and the behaviour of those assets. See our article in the Mar/Apr 2010 edition of Engaged Investor for further information on DGFs.

In terms of governance, the broader message is that simply dumping members into a poorly-designed equity-only fund is no longer acceptable. It’s dangerously easy for trustees to think that because a poor investment decision only affects individuals’ retirement pots that the impact is less than a poor decision in DB where the resultant loss will show up on the sponsor’s profit and loss sheets. But, for the retirement prospects of those individuals, the impact is massive – and ultimately that cost will fall back on the sponsor when members are unable to retire.

To address the problems of poor investment choices a group of senior practitioners from across the pensions industry has created a set of ‘best practice’ guidelines for DC governance, under the auspices of the Investment Governance Group. See the boxout on page 30 for further details.

Act II: administration

“A few years ago, everyone thought that as DB administration was so complex, DC administration would be a cinch in comparison,” says Harper of Hewitt. In truth, DC administration isn’t easier – it’s simply different. For example, if trustees discover a mistake in their DB administration, such as missing contributions or an incorrect calculation, it’s possible to rectify it over time. DC administration has to be right first time: each members’ pot is a separate investment and so payments have to be correctly logged right from the start. If problems go undetected for long periods of time the cost and complexity of fixing them can be horrendous. “A serious problem could even mean getting the scheme reconstructed,” says Harper.

Getting an administrator that truly understands DC administration and is able to carry out tasks such as reconciling payments effectively is absolutely vital. “You need to make sure that you go into the details of how things are being done with your administrator,” says Nita Tinn of independent trustees ITS. “Ask how the lifestyling process (ie the way in which members’ investments change over time to generate returns and/or reduce risk as they reach retirement) is happening, for example.”

One of the cornerstones of good administration is high quality data. The Pensions Regulator’s recent communications on record-keeping (see Engaged Investor, Jan/Feb 2010) have set out some clear standards and requirements for data and record-keeping, but these are just the basics. Holding good quality information about members not only means that their benefits are held and calculated correctly – it also means that you can target communications more effectively. And effective communication is perhaps the biggest governance challenge of all for DC scheme trustees.

Programme notes: communication and member understanding

While trustees might be responsible for the design of the fund range and the structure of the default fund, it is still ultimately up to the member to decide where to invest his or her money.

But how many members truly understand the funds in the range that they are being offered? Do they choose the default fund because it genuinely suits their needs, through inertia, or because they believe it to be the best simply because it’s been chosen as the default fund? Do they appreciate their pension as an employer benefit, and do they understand what to do with it when they actually retire?

Answering these questions – and a host of others – requires good quality communications. The DB-style approach of issuing an annual member statement just isn’t appropriate in a world where members’ pensions are influenced by their own decision-making. And, while websites for modelling retirement aspirations, videos explaining investment choices or even face-to-face sessions with members all have their part to play in improving communications, if they are not delivered in the right way and at the right time, they won’t have the desired effect.

Providing generic member education can make minimal difference – “inertia and accepting the status quo are very much in evidence in the DC world,” says Douglas of BlackRock. “Members are surprisingly complacent,” agrees Tinn of ITS. “Even when they receive information they often don’t respond to it. The type and quality of information is vital.”

Getting the messages, timing and form of delivery correct comes down to knowing your members as well as possible. Information such as members’ ages, and whether or not they are married should be accessible from your administrator, but that won’t tell you whether members would prefer to receive communications online or on paper – or if they read the communications that you send them already.

Using the internet for information and for collecting member information such as fund choices is an alternative to paper – but certainly not a complete solution. Warne, of Aviva Investors says: “For online tools, take-up rates are woefully low. We are looking at single percentages.” He says that Aviva has recently introduced a new DC-specific communications tool for the schemes that it supports. The package includes videos as well as other online tools to educate and support members. “It has raised engagement rates, but to around 25 per cent. That’s still not enough.”

Cracking member communications sits at the heart of good DC scheme governance and is a huge subject of critical importance for the trustees of all DC schemes. That’s not just because it affects members’ investment decisions, but because it’s also a vital element of making sure that trustees have done their job properly. Says Harper of Hewitt: “The Pensions Ombudsman is seeing more cases relating to DC pensions. You need to make sure that you have a proper audit trail for your communications – and a proper risk strategy for your scheme overall.”

THE SEQUEL: INVESTMENT GOVERNANCE GROUP

In recognition of the increasing importance of good governance for DC scheme investments, a group of senior pensions industry figures has developed a consultation paper on best practice in DC investment, under the auspices of the Investment Governance Group (IGG).

In essence, this offers a set of guidelines that mirror the Myners’ Principles – the set of guidelines for DB decision making established by Paul Myners in 2001 – but aimed specifically at DC schemes.

A consultation period on the IGG’s paper closed in early May.

The paper is broken down into four main parts:

1. A framework of legal and regulatory requirements, with a focus on what trustees (and others) must do to improve transparency, accountability, fund governance and decision-making.

2. A set of principles for investment decision making. While not legally binding, the paper proposes a ‘comply or explain’ approach to the guidelines.

3. A check-list of best practice guidance, to help schemes meet the aims of the principles.

4. A table of accountabilities that shows the responsibilities of each decision maker within the DC structure (including trustees) at each decision-making stage.

Industry response so far has been mixed, with Standard Life branding the guidelines ‘elitist’ and biased towards trust-based schemes.