February 2012

By Charlotte Moore

Now that the last FTSE 100 DB scheme has closed its doors, and auto-enrolment is on the horizon, Charlotte Moore examines whether the spotlight will finally shine on DC scheme design

Shell recently closed its defined benefit scheme to new members. There are no longer any FTSE 100 companies with open DB schemes. While this is an interesting milestone, it’s hardly surprising: the defined benefit scheme has been dying a slow death for many years.

Any pension professional knows that the future of employer pension provision is defined contributions. Yet most of the attention of the industry has remained stubbornly focused on DB schemes.

DCisions business development director Nigel Aston says: “If a large company has both a DB and DC scheme, then most of the people who actually work at the company are members of the DC plan, whereas the DB members have either left or are already retired. Yet trustees spend 90 per cent of their time on the DB plan. It’s a crazy situation.”

The introduction of auto-enrolment has finally galvanised the industry into focusing on the future.

It’s hard to underestimate the impact of auto-enrolment on the pensions industry. It’s estimated that five to nine million more people will be added to company pension schemes. The minimum contributions have been set: eight per cent of qualifying earnings need to be paid into a DC plan, with a minimum three per cent contribution coming from employers.

For some companies, the sudden influx of employees who were previously not eligible for the company pension scheme will be a significant additional cost, especially in times of economic hardship. That’s why the government has agreed to allow small businesses to push back the date to 2015.

The introduction of auto-enrolment and Nest seems to have focused the attention of both The Pensions Regulator and the industry on a thorny topic: just what constitutes a good DC scheme?

The design of the DC scheme is likely to create conflict between the company’s finance director and the human resources department.

Zurich head of corporate wealth propositions David Lowe says: “The finance director will want to minimise costs and the human resources department will want employees to value the benefit. In a large company, that’s typically the starting point for designing a DC scheme.”

In recent months, however, The Pensions Regulator has put the kibosh on any company taking a laissez-faire attitude towards the DC scheme by reminding companies of the responsibilities towards their scheme members.

Mercer head of the auto-enrolment initiative Rachel Brougham says: “The regulator is pushing very hard on DC governance at the moment. Last year they highlighted the need for trustees to focus on enabling a good outcome for scheme members. DC schemes must have a good default fund and a good choice of investment products, which are appropriate for the membership, to help to fulfil that criteria.”

Aon Hewitt benefits consultant John Foster concurs: “Over the past 12 months, the regulator has said that member outcomes are a key consideration of the trustee’s responsibility. That’s an evolution because that was not explicit in the past.” Instead, the regulator had focused on the risks for the scheme members such as lack of understanding and administration errors.

“Ensuring the best outcome for the scheme members means that the company or trustee needs to understand the scheme by analysing its membership. Then the design and strategy that’s adopted for the scheme needs to be linked to those members’ needs,” adds Foster.

Providers of DC schemes admit that they have learnt some interesting lessons over the past few years. Many put a lot of effort into trying to educate their employees about the basics of investing.

The industry now realises this was an unmitigated disaster. Aston says: “The industry has spent the last 10 years trying to educate people about equities, bond and cash. That was perhaps not the right decision. It’s like trying to teach someone who wants to buy a car how an internal combustion engine works.”
The reality is that employees are not engaged and around 90 per cent of employees simply choose the default fund. Companies are best served by focusing their efforts on ensuring that this default fund is fit for purpose.

Foster says: “There is a move towards a greater diversification of assets away from equities in default funds, particularly for those scheme members who are in their mid to later career and want to crystallise some of the gains but still have access to assets that can make real returns with less volatility than equity markets.”

This transition through different types of asset classes over the course of a scheme member’s life is known in the industry as a lifestyle strategy and this type of approach has been adopted by many default funds.

The idea is that a scheme member will be invested in high return, higher risk assets like equities at the start of their career. As they get older they will move out of higher risk asset classes into less risky asset classes to protect the capital gains that their portfolio has built up over the course of their working life.

Protecting the capital value of a pension portfolio makes good sense but some say that lifestyle strategies can create problems, especially when it comes to making changes to the default fund.

Last year the Department for Work and Pensions laid out its guidance on how companies should treat the default scheme. As well as saying that the default scheme needs to consider the risk and return needs of the members, it also said that the default fund should be regularly reviewed and changed if necessary.

While many companies acknowledge that default funds should be regularly reviewed, very few actually change these funds. AllianceBernstein head of DC Sales and client relations Tim Banks says: “We carried out a number of surveys and found that only around 30 per cet of schemes had ever changed any aspect of their default fund since the inception of the plan.”

Aston says: “We compare the strategies that asset managers recommend to those setting up default funds against the solutions that actually end up being used. There is often a big difference between the two.”

There are plenty of fund managers with smart ideas about how the default fund should be designed but these concepts are not being implemented quickly.

“Many schemes are taking a ‘set and forget’ mentality. While they say that they will review the default fund, few actually implement any changes,” adds Aston.
Banks says that lifestyle strategy is a key impediment to changing the default fund. “Everyone in the fund is on an individual mechanistic strategy so if the strategy or the fund manager components need to be changed, members have to be contacted and these changes have to be communicated. It takes a lot of time and money for the administrator to make all these changes.”

AllianceBernstein offers flexible target date funds. These funds target the members’ anticipated retirement date. “The advantage of a flexible target date model is that it keeps it simple for members and keeps the investment strategy under the bonnet. That means that if anything needs to be changed it can be done quickly and easily and without disrupting members,” says Banks.

But others in the industry say that target date funds also have their problems. Aston says: “Giving the responsibility for changing the default fund to the trustee board or an investment professional does not guarantee that the right decisions will always be made.”

Even though DC schemes have been in existence for at least decade, this industry still feels like it’s in its nascent phase, Legal & General Investment Management client relationship manager Richard Skipsey says: “The reality is that there is currently no benchmark nor any consensus on what approach is the best one for the default scheme.”

Now that regulator has put the spotlight on the design of DC schemes, there will be much more debate about how to design the best default scheme and a thorough review of existing plans to see if they are fit for purpose.

Written by Charlotte Moore, a freelance journalist