Contract and trust equal partners?

The performance of default funds is crucial given that most employees sign up to that option when they join a scheme. But which default is best? A default fund offered by trust-based scheme, or a fund that is offered by a contract-based scheme.

It is a hard nut to crack, although PensionDCisions is having a go in its latest Sponsor Default survey, due out soon. The survey examines a sample of the biggest schemes in the UK, and the firm says that early indications of its number-crunching “suggest a significant dispersion of performance and a wide range of risk levels”.

But the survey will show that contract- based schemes have generally outperformed over the past year while trust-based schemes have performed better over the past three-years.

Nigel Aston, business development director at PensionDCisions, says that one reason behind this early finding is the likelihood that contract-based schemes have a higher equity weighting than trust-based schemes (around 5 per cent more), many of which have been embracing the new cult of diversification of adding private equity, commodities and property to the mix at the expense of shares.

He adds: “Contract-based schemes seem to have done better over the short-term, perhaps because of their tendency to be more heavily exposedto equities. Whether this is intentional, or a lucky consequence of not being quick to diversify in the light of the recent bear market is difficult to determine.”

Trustees have the capability to be more nimble but it is a question of whether they have better people and whether they meet enough and have access to key information. If they are meeting just once a year, then that is of little use

Rationality suggests that trustbased schemes should deliver better results, although many experts argue that there is not always a difference to performance. Standard Life, for instance, offers a range of similar funds to both contract customers and trust schemes.

“Many trust schemes are using the same default funds as contract schemes and, therefore, in these situations there is no performance difference,” says John Lawson at Standard Life.

“Most schemes today, trust and contract, use lifestyling within their default, but may differ on the composition of the fund up until its glide path into fixed interest and cash in the five to 10 years running up to retirement. The trend in recent years has been to use passive in the accumulation
phase, almost always with a high if not 100 per cent equity content, but that is now changing.”

Whether a trust-based scheme is better or not will be down to the personnel in charge – and whether they have the inclination to make the most of their advantages. If they do, then trust-based schemes should deliver superior results. On the other hand, if they don’t they will under perform.

It is a point highlighted by Aston: “Trustees have the capability to be more nimble but it is a question of whether they have better people and whether they meet enough and have access to key information. If they are meeting just once a year, then that is of little use.”

Brian Henderson at Mercer says that contract-based schemes are akin to “super-tankers” in that they are hard to move because they are fixed contracts.

Henderson adds: “There is advice to set up a contract scheme but then they are left alone. Typically providers will have 80 funds – some have up to 200 funds on a platform yet many are simply put on for all sorts of marketing reasons. Yet trusts can hire and fire and have the ability to move things around and improve performance.”

Julian Webb, head of DC at Fidelity, agrees that the principles behind trustbased schemes suggest that over the long term they should outperform because they have the ability to adapt and monitor performance. “They can look at returns and volatility, which contract-based plans cannot easily do,” he says.

Trustees and their advisers are building default strategies that hedge out much of the volatility of equity-based funds without removing all of the equity out performance

But despite the difficulties, the DC landscape is starting to change – albeit slowly. Many of the very factors that should make trust-based schemes superior are being introduced, where possible into the contract-based arena. Webb believes that contract-based schemes should offer more to members and that they should have some
of the benefits enjoyed by members of
trust-based schemes.

It is why the Fidelity is about to launch its multi-asset growth fund, which is making headway in the DB and trust-based DC sector, into the contract- based sector. “It will give members access to assets such as commodities and the fund’s manager, Trevor Greetham, will be able to tweak asset allocation to suit economic and market conditions,” adds Webb.

Governance also used to be the domain of the trustee-based scheme, but that is no longer the case. Some providers are introducing fund ranges that are more closely aligned to trust based schemes. They offer a more hands on approach and increased flex flexibility
with regards to the underlying
assets.

Besides, not reviewing the default fund goes against the regulator’s wishes -whether it is a contract-based scheme or a trust-based one. With the employer and employee ducking responsibility, white-labelled funds that are already making headway in the trustee-based arena could be a solution for GPPs.

Three-quarters of trust-based schemes are now using an investment gateway (or platform) to deliver their investment strategy, of which over 40 per cent now use a scheme-specific ’white-labelling’ structure to do so. Such white-labelled default funds could be the answer for contract-based schemes because the underlying funds can be switched without the need for consent from employees. White-labelling is most common on unbundled schemes using an investment platform but consultants say that it can just as easily be achieved on bundled trust-based schemes. They say that in theory, it could just as easily be achieved on contract-based arrangements as most providers’ administration platforms are used for both trust- and contract-based arrangements.

Helen Dowsey, consultant at Aon, says: “It is more problematic on contract- based arrangements – and this, I believe, is the biggest key differentiator from an investment perspective for trust- and contract-based arrangements – potentially leading to the biggest difference in performance over the longer term. Because the contract is between the provider and the member, investments cannot be changed without an explicit instruction from the member.

She adds: “Some providers have identified a way around this issue – by operating a white labelled default option with advice given to the provider (rather than the employer or member) on the underlying investments by the consultant. This way of operating white-labelled funds in a contract-based arrangement is quite new but puts trust and contract based arrangements on more of a level playing field from an investment perspective.”

Many providers are already moving towards this pseudo-trustee model. Scottish Life has been making a noise about its “market leading” investment proposition to help advisers and employers with governance. It is not alone – the likes of Fidelity, Aegon and Scottish Widows, offer similar solutions in the contract-based market too.

Scottish Life’s Governed range means that there is a formal review process, which includes an investment advisory committee to review investments and the use of analysis from risk management experts. “Which type of scheme is better is difficult to answer. Performance will vary from one group of trustees to another, whereas there should be more consistent performance in the contract-
based arrangement – though possibly not as deep or extensive,” says Alasdair Buchanan, head of communications at Scottish Life.

“There will be examples of good and poor in both categories. We offer both and there are many common features with the main difference being
the responsibilities. So governance is clearly the responsibility of the trustees in an occupational scheme.”

Contractbased schemes seem to have done better over the short-term, perhaps because of their tendency to be more heavily exposed to equities.Whether this is intentional, or a lucky consequence of not being quick to diversify in the light of the recent bear market is difficult to determine

But while efforts are being made to close the gap, the inflexibility of contract- based schemes (in that they are a fixed contract with an individual) will continue to create stumbling blocks. Newer strategies that involve complex investments may get lost in translation to employees.

Lawson says: “Trustees and their advisers are building default strategies that hedge out much of the volatility of equity-based funds without
removing all of the equity out performance. Our Global Absolute Return Strategies fund has been hugely successful here.

“But making an absolute return fund the default under a contract scheme is a bit trickier because the buyer is no longer a knowledgeable professional who understands how hedging strategies using swaps and
options works.

“Explaining how such a fund works to the layman in a way they will understand is difficult but not impossible – governance committees (and their professional investment advisers) can certainly help, even though they are not legally responsible.”

Trust-based schemes should deliver better results over the longterm, and Pada obviously agrees, hence its board of trustees for Nest. Yet, there will be circumstances when they underperform their contractbased counterparts. Just as active fund managers should be able to add value over and above a benchmark index, most frequently disappoint. Too much tinkering and wrong asset allocation calls from the trustees will have a detrimental impact on the performance of trust-based schemes.

As Ashton concludes: “Regardless of how the scheme is set up, the winning formula for governance would seem to be a combination of experienced and empowered people, meeting regularly and with access to great information. There is room for improvement in DC, in both camps.”

EXPERT VIEW DC PENSION PLANS – TRUST BASED V CONTRACT BASED

There are numerous articles comparing the merits of trust based defined contribution (DC) pensions with contract based, GPPs and Group Stakeholder Plans. With ever changing legislation and pension bodies placing greater emphasis on the need for governance and best practice, some of these merits are falling away whilst other challenges are arising.

Best Practice and Governance
Whilst contract based arrangements are not subject to the strict regulations surrounding trust based schemes, many contract based schemes are opting to self impose these to ensure best practice. The NAPF’s Pension Quality Mark aims to establish a new ’kitemark’ for DC pensions. As an aside, achieving a PQM is also likely to mean an exemption from the Nest proposals from 2012. In broad terms, in order to achieve a PQM a pension scheme must meet certain criteria, such as:

 

• Formation of a Governance Committee – although this is not a formal body (as compared to a Trustee body) the group will meet at least annually to consider the pension and ensure it is well run.
• Annual Review – Generally prepared by the scheme advisers for consideration by the Governance Committee
• Simple Investment options – A default investment option or a limited selection from a range of risk rated funds must be offered. Interactive tools, presentation or face to face meetings should accompany a wider fund choice.
• Charges – Effectively, no more than a 1% base AMC.
• Communication – This must be provided at the outset, on an ongoing basis and at retirement. The communication must be clear and simple to understand.

These guidelines are very similar to those surrounding trust based DCs and to the Pensions Regulator’s paper on good DC governance. So, if the NAPF and the Pensions Regulator achieve their aims and this becomes best practice for DC, then it does not matter whether companies choose trust or contract; essentially best practice as defined above will become the norm.

So what now are the differentiators between trust and contract based? I believe the key differences are the regulatory body and the employer/advisers involved.

Contract based pensions are regulated by the Financial Services Authority and therefore the Retail Distribution Review (RDR) and the Distributor Influenced Funds (DIF) papers do have to be taken into account. In the current proposals, trust based schemes will not be covered by the RDR and therefore some advisers may be able to find a more appropriate solution for their client in terms of remuneration; this of course depends on the services offered and quality of work.

The last key point is DIF. Under a trust based scheme, the Trustees can make decisions that they believe are in the members best interest without having to wait for member consent. As such, if the investment adviser makes a recommendation to switch, for instance, a UK equity manager this can be achieved with very little red tape. Similarly, a range of bespoke, blended funds can easily be created with differing risk profiles for a trust based scheme and the underlying managers can easily be changed if required. These changes are difficult to implement under contract based schemes as individual member consent is required.

Will we see a shift back towards trust based? Well it certainly should be considered.