When defined contribution pension scheme members saw billions wiped from the the value of their plans following the recent collapse of the global stock markets, many individuals asked whether more could have been done to protect their savings. While DC schemes have previously been characterised by saver apathy and general disinterest, such dismal returns have led to greater focus on improving DC governance.
Ever since contract-based DC schemes, such as group personal pensions (GPPs) and stakeholder plans came to replace more expensive DB provision, there has been considerable concern in the industry that individuals have been cut adrift from the protection enjoyed by final salary scheme members. The laws governing DB schemes in the UK are some of the most stringent among OECD nations and the government continues to strengthen governance requirements, most recently through the trustee knowledge and understanding legislation in the Pensions Act 2004.
Conversely, no such provisions exist for contract-based DC schemes, which means not only do individuals bear all the investment risk, in many cases they are also afforded little in the way of formal oversight for the overall running of their scheme.
Nick Eade, sales support manager at JLT Benefit Solutions, says: “It’s not fair to cut a member loose on a DC arrangement, particularly where they have been managed in the past by a board of trustees. Individuals don’t tend to understand pensions and it’s a big thing to move from an occupational pensions arena where investment decisions can be taken by trustees, to contract-based DC.”
He adds: “Members need an element of comfort that at least some aspects of the new contract-based scheme are being monitored by the employer.”
In light of the limited statutory protection for members of contract-based DC plans, the Pensions Regulator has issued guidance on best practice for employers and fiduciaries. In a statement issued in July this year, TPR chief executive Tony Hobman made clear his desire to see improved standards for this type of retirement provision.
He said: “It is more important than ever in these challenging economic times for members to make the right decisions to maximise value for money at retirement. In the run-up to 2012 we are focusing on providing more education to assist employers with their pension provision and are looking at the standards in key processes for DC pensions. We are willing to enforce better practice if we need to.”
The pensions watchdog argues that it is in all members’ best interests if a GPP or stakeholder scheme is reviewed periodically, and notes that such practices reduce risks to the employer while improving employees’ perceptions of the value of saving into a DC scheme. However the regulator stops short of saying all employers should set up a governance committee, stating that no ‘one size fits all’ approach can be applied to good DC governance.
It appears that the regulator’s focus on DC governance best practice is filtering through to employers. According to the Watson Wyatt Future of DC Governance survey, which interviewed 60 DC schemes and was published in July, 90 per cent of employers running DC schemes believed that good governance reduced risks, while 80 per cent said it improved retirement income.
Watson Wyatt divides the work of governance committees into two camps: operational and qualitative. The former deals with activities such as monitoring administration and overseeing providers, while qualitative governance includes member engagement, communications and investment. Among respondents to Watson Wyatt’s survey, the operational element of DC governance was widely prevalent, but the qualitative element remained largely aspirational. In particular, employers were keen to work on improving investment strategies.
Gary Smith, senior consultant at Watson Wyatt, says: “Fiduciaries increasingly believe they should be doing more to help DC members and clearly want to focus more on qualitative approaches. There is an acknowledgement that added value and risk management are the two main factors focusing their minds when prioritising the allocation of scarce resources. We would agree that investment is the area where good governance can add the most value and where members struggle most.”
Ever since the advent of stakeholder schemes at the start of this decade, the adequacy and appropriateness of default funds, into which the lion’s share of members fall, have come in for intense scrutiny. Attempts to offer an investment strategy that suits an entire membership have long been criticised, and DC governance committees offer some opportunity to better tailor default funds to a company’s demographic.
Alistair Byrne, senior adviser at consultancy AllenbridgeEpic, says: “If the default fund isn’t appropriate for certain segments of the membership, the governance committee can make sure the members are getting the best options. It can analyse what the members are doing and relay that information to the relevant parties.”
Byrne adds that governance committees can also ‘white label’ DC default funds for their contract-based schemes, although this remains uncommon.
“There is some scope to do the white label approach where the governance committee can get involved in structuring default funds and having the right package provided. Few committees have actually gone down that path, because they are reluctant to have that degree of involvement. With investment decisions there is always scope to get things wrong and the worry is that their decisions will come back on them,” Byrne says.
Alongside improving the investment options on offer, DC committees can offer effective monitoring and oversight of the scheme’s providers. Logica, one of the UK’s largest company DC schemes, has recently turned its ad hoc governance committee into a permanent arrangement, meeting once a year to oversee the plan. The committee is made up of the chairman of trustees, the chairman of the audit committee, an independent trustee and a deferred member trustee.
The advent of a formal governance committee has, according to Simon Baynes, chairman of trustees at Logica and who also chairs the governance committee, improved efficiency for the scheme and helped save the company money. For example, provider and supplier reviews are now scheduled to occur at timely intervals, which helps the company with budgeting.
Baynes explains: “The governance committee has removed some of the irregular activities. We tend to review our suppliers every five years, so we’d end up reviewing two or three of them in the same year while in other years we’d do nothing.”
He adds: “Now we’ll do investment managers one year, administrators the next year, lawyers the next year and so on. By spreading it out we can help the company with budgeting – important in the current environment.”
Logica’s governance committee also oversees the risk register which grades risks facing the schemes on a traffic light system – red risks are reviewed every quarter, amber once a year and green are ongoing.
“The governance committee will make sure those risks are being properly reviewed and actions are being taken to mitigate them,” Baynes says.
However, Baynes notes the committee’s effectiveness is largely attributable to the governance plan which was put in place four years ago and lays out the direction the scheme will take over the next few years.
“The governance committee is the owner of the governance plan which is what drives the committee. Having a governance committee isn’t essential but having a plan is; it is the plan which is the crucial element,” he says.
The Logica case highlights the importance of ensuring a governance committee has a clear set of objectives, and is afforded the power to make decisions and implement change. Roger Breeden, principal at Mercer, believes the initial construction of the governance committee is critical.
“If the committee’s structure is not really thought through at the outset and it’s just a group of people who informally get together to see how things are going, then probably it won’t work. But if it is more structured and defined, and people understand what is expected and how they measure success, then it’s more likely there will be a stronger impact,” he says.
In spite of this argument, much of the current DC governance remains an informal arrangement between key management individuals within a firm. AllenbridgeEpic’s Byrne notes that at a lot of companies the finance director meets informally with the HR director and pensions manager to examine the DC scheme, because employers are reluctant to put in place more permanent infrastructure. However, he argues that formalising these unofficial arrangements can be beneficial to both employer and scheme members.
“If meetings are already happening it may make sense to formalise them in the shape of a committee and think about who else should be involved. There is a case for having committees in place to stop problems arising in the future; it’s an investment worth making,” he says.
Making such an investment, however, can be a challenge for smaller and medium-sized schemes. The extent to which Logica can follow DC governance best practice is aided by its advantageous position as a large, well resourced pension fund allowing it to capitalise on economies of scale and internal expertise. For Logica’s smaller counterparts, implementing a governance committee can prove more of a drain.
Breeden says: “Governance committees are emerging within all sorts of employers, but generally you see them at the larger organisations particularly where they are coming from, or still have, a trustee structure in place for the DB plan. The companies that will adapt to it more easily have already got some experience and infrastructure to run the committee.”
The chart below shows the key barriers to improving DC governance cited by respondents to the Watson Wyatt survey, with more than half claiming lack of time was a key hindrance to implementing a committee.
However, Eade argues that all companies, irrespective of size, can profit from putting a governance committee in place, and notes that the demands of such an arrangement on time and resource are limited. “You don’t have to have monthly meetings. For DC arrangements you can have two a year or annually; as long as you have something there for people refer to, that’s the key,” Eade says.
A lack of experienced or knowledgeable individuals to make up a governance committee presents another problem for some employers with contract-based DC. More than a third (38 per cent) of respondents to the Watson Wyatt survey said lack of expertise prevented them from putting a suitable governance committee in place; an issue which may be made more acute by lack of direction or guidance on what makes a suitable governance committee candidate.
Breeden says: “There is no legal constitution for a governance committee, but if individuals take on roles and responsibilities then their skills need to be commensurate with that. If the governance terms of reference are quite wide ranging and they are empowered, then they should have the relevant expertise or work with advisers who have the relevant expertise to support them.”
While outsourcing issues to a sub-committee or adviser offers a solution to gaps in a DC governance committee’s knowledge, the individuals who make up the panel must be able to challenge the advice and guidance they receive. AllenbridgeEpic’s Byrne says that independent thinking is a key selection criterion.
“If you are putting a group together like that then you should be looking for people with independent minds who are prepared to challenge in the same way that you would with a trustee board,” he says.
Just one-quarter of the UK’s contract-based DC schemes have a formal governance committee in place according to the National Association of Pension Funds’ 2008 annual survey, highlighting just how far there is to go before DC committees could be considered commonplace. However, the impetus from TPR coupled with a heightened interest from members themselves should act as motivation for change. But employers need to bear in mind that a committee alone is unlikely to result in improved governance; it must be supported by clear objectives, appropriate expertise, strong leadership, and the ability to implement key decisions to effect change.