The Risks faced by Trustees of DC Schemes - and How to Control Them

31 Mar 2003

Law Debenture Pension Trust Corporation p.l.c.

[Article for PMI News]

The Risks Faced by Trustees of DC Schemes and How to Control Them

Everyone knows that money purchase schemes are intended to transfer risk from employers to members. But the responsibilities and risks facing trustees remain onerous. They are at least every bit as demanding as in defined benefit arrangements – but in a different way. (Whether money purchase schemes do in fact transfer all risk from employers is another story, or rather article.)

How and why is a trustee’s role different in money purchase schemes? It is different precisely because of the risks which members face. Trustees have to make sure that there are appropriate investment choices for members. They also have to make sure that members have a chance of responding in an informed way to the risks they face.

The guiding general question which I suggest that trustees should ask is: have we done all that we reasonably can to give the member the best chance of making sensible decisions? Trustees can’t afford to set a lower standard. If trustees adopt the approach of just doing the minimum that is necessary to “comply” with the letter of regulation, then disappointment lies ahead. And if members are disappointed they will look for someone to shoot at.

The scope for disappointment is frightening. Rather than accruing, say, 60ths of final salary in an occupational scheme, there is a real danger that members of money purchase schemes will discover all too late that they have accrued an inadequate pension equivalent to, say, 120ths – or worse. Given current average levels of contributions this is a real risk. If this does happen, we can be sure that members will be looking for someone to attack. If we, as trustees, have not done all we reasonably could to give the member the best chance of ending up with a reasonable pension, how are we going to be able to defend ourselves?

I would predict that the understanding of the duties of trustees of money purchase schemes will become more detailed and precise as trustees and their advisers develop the “state of the art” – trustees will be expected to live up to increasing standards as best practice in this under-developed area is refined.

So, what are the main risks, and how should trustees respond?

The Trust Deed As in so many situations, the starting point is the trust deed and rules. Trustees must be familiar with it, and should identify the responsibilities which it gives to them – either expressly or by implication. In this article I assume that the trust deed makes the trustees responsible for the duties which I discuss.

Investment choices There should be sufficient choices to give a wide enough range of options to members to satisfy the reasonable return and risk combinations appropriate for most members (to quote from the second principle of the Myners Code). In my view this is likely to require (at least): an equity fund; a bond fund; a cash fund; and a “lifecycle” (or “lifestyle”) fund. The number of funds should not be excessive – most risk/return combinations can be achieved with a small number of funds, and introducing more funds risks harmful confusion and avoidable costs. Clearly trustees should also bear in mind the degree of investment knowledge possessed by their members.

There is not space to discuss investment choices in much more detail, but I would add that there is a strong case for including overseas equities – in order to diversify risk. I would also suggest that trustees should start with a presumption of favouring passive management – to avoid the risk of significant under-performance.

The default fund Debate rumbles about whether there should be a default fund, and if so what it should be. In my view a default is desirable – because we know that many members will be unsure about what they should do, although membership forms should encourage members to make a choice. This is why most members opt for the default where one exists (take-up in excess of 80% is common). It is naïve simply to repeat the mantra of suggesting taking independent advice when we know for a fact that this is unlikely to be heeded. And for schemes which have automatic entry some form of default is essential – because something has to be done with the funds of members who fail to make a choice - so why not invest funds sensibly?

The “lifecycle” option I would strongly recommend this option (designed to reduce risk as retirement approaches), which will also form a sensible default option for many schemes. Why? Because for most members this will be the sensible investment choice – as it seeks to obtain the benefit of exposure to equity, but restrict the risk as retirement approaches - so it should be made readily available.

Careful thought needs to be given to the design of the lifecycle option – including the investment vehicle for the initial years, the period over which transition occurs, how the transition works (e.g. monthly or quarterly switches of investments); whether members can set (and alter) their target retirement ages and the final asset allocation. The design of the lifecycle option will need to be kept under review – there have been advances over recent years, and it is not sensible to stick with an out-dated design.

Scheme Rules Some schemes have rules which set out specifically what the investment options will be. But trustees can’t just breath a sigh of relief. If they consider that the investment choices are or become inappropriate for members then they should raise their concern with the sponsoring employer. Of course, the employer might not agree to a change, but in many cases the request is met with co-operation. I would add that the employer must be consulted about changes to investment options and arrangements which require a change to the scheme’s Statement of Investment Principles.

Communication This is a key challenge, and risk, and trustees need to respect the fine line between providing information and giving advice. Communication should be sufficient to give members a fair chance of making sensible choices. Communication must give members full opportunity to understand how the scheme works, and the nature of the risks they face. The members need to understand the risk and return characteristics of the investment choices – so as to avoid taking too much, or too little risk.

Over time members must also be encouraged, and helped, to review both the amount of their contributions and their investment strategy. Members must also be given useful and intelligible information about the performance of their funds. These will be areas which are unfamiliar to many members, and so great care will be needed to make sure that an adequate explanation is given. A patient approach using plain English is key.

Generally the responsibility for communication lies with the trustees. So, for example, the disclosure regulations place the duty of disclosure on trustees. However, trustees should seek to work with their sponsoring employer in designing a communications strategy. Trustees should also bear in mind that deferred members continue to need appropriate communication.

Should the scheme go further and arrange for advice to be provided to members? I predict that this will become increasingly common. Why? Because without it I fear that too many members will be left floundering. We know that members will not take individual non-commission based advice. Trustees, of course, can’t generally give investment advice. But we should consider whether there is a cost-effective means of making advice available – perhaps by workplace seminars, perhaps by video presentation. This costs – and trustees should take the initiative and discuss whether the sponsoring employer is prepared to meet the cost. Increasingly the design of good schemes will allow for more sophisticated and individual information and advice.

Monitoring investment choices Members can reasonably expect that trustees will keep the performance and continuing suitability of investment choices under regular review. In most, if not all, cases trustees will need the help of an investment consultant. Just as much care needs to be taken with monitoring as for a defined benefit scheme – as the trustees’ actions will have a direct bearing on members’ benefits.

A word about administration Defined contribution administration is time critical: money must be invested promptly and in the right funds. Liaison with the company payroll and with the investment managers is crucial. If not, then members will have good cause to complain – and reclaim any loss. Correcting past errors is likely to be costly. And remember that trustees are ultimately responsible for the administration of schemes. So, if administrators are selected principally on cost grounds, and if their work is not carefully scrutinised, members, and ultimately trustees, will suffer.

Annuities Trustees should focus at an early stage on how a member’s “pot” is converted into pension. Schemes can be set up with little practical thought being given about how pensions will be bought for members – after all, this will be some years away for the vast bulk of members. But it is not sufficient simply to have rules which deal with what happens at this crucial juncture – there must be a practical and efficient system. Trustees should seek to help members to shop around for the best annuity option for them taking into account their circumstances – perhaps by an arrangement with an annuity broker.

Schemes with final salary and money purchase sections Typically in such schemes the final salary section will be large and mature, and the money purchase section will be smaller and more recently established. Trustees should beware the temptation to treat the money purchase section as “any other business”. The defined contribution section will normally be as deserving of care and attention as the larger and more familiar final salary section. A lack of care and attention in the early days can result in reaping a harvest of major risks and liability later on. Trustees should consider setting aside meetings just to consider the money purchase section (and AVCs in both sections), or alternatively setting up a committee charged with some of the main responsibilities relating to the section.

What would be my top ten tips for controlling, and hopefully avoiding risk? In no particular order I would offer these suggestions:

Always keep the scheme’s trust deed and rules in mind.
Read and implement the Myners Code – much of it is common sense, but none the worse for that.
Review investment design and choices regularly.
Seek feedback from members and monitor choice patterns.
Take every chance to encourage active members to review the adequacy of their contributions, and to encourage both active and deferred members to review the appropriateness of their investment strategy.
Seek to develop and improve communication as an ongoing challenge.
Seek to use intra/internet as a supplement to other forms of communication.
Take time to understand your administrators, their current performance and plans. Don’t assume that a good DB administrator will necessarily be the best choice for a DC scheme.
Take professional advice about investment choices, performance and communication – and remember the most expensive advice is that which is not taken.
Try to put yourself in the shoes of a member who knows little about pensions, investment strategy or risk.

Mark H Ashworth
Law Debenture
February 2003

Pension Trusteeship

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