There seems to be a widespread view that good fiduciary oversight of the investment strategy for defined contribution pensions is more difficult in contract-based schemes than in their trust-based counterparts.
I beg to differ. The arrival of modern flexible target date funds (TDFs) means that equally robust investment governance can be delivered in both types of arrangement. The beauty of TDFs from a governance point of view is their simplicity. There is no need for any complicated fiduciary oversight to be tacked on: it is actually built into the design.
This means that, as in all good governance arrangements, TDFs ensure that the management process is separated completely from the monitoring function. So, where a contract-based arrangement uses TDFs, the employer still sets the objectives for the scheme, but a professional fund manager is made responsible for ensuring that the investment approach meets those requirements. The employer and their adviser can then monitor whether or not those objectives are indeed being met by the investment strategy.
The crucial factor is that the employer doesn’t actively manage the assets. This doesn’t mean they can’t choose the managers and the type of assets , or indeed whether the assets are to be actively or passively managed. What it does mean is that, once those initial decisions have been made, a completely separate professional has the responsibility of managing them in accordance with the objectives laid down. By keeping management at arm’s length in this way, we believe the employer can be much more objective in assessing whether the default approach is meeting their members’ objectives right across the age range.
Moreover, this separation of roles can only serve to improve the image of the scheme in the eyes of both the employee and the regulator. After all, good governance must not only be done, but be seen to be done.
But the fiduciary responsibilities of those providing a pension scheme – whether contract-based or trust-based – go much wider than that. They also have a role in ensuring that the level of return being sought from the assets is commensurate with the risks being run. After all, very few members of DC schemes – if any – have the requisite knowledge, yet it is they who are ultimately on the hook for their own pension income. It could therefore be argued that it is the responsibility of the provider to ensure that a suitable risk-reward balance is achieved in order to show that they have used best efforts to achieve a good outcome for members.
Again, the crucial factor here is design. Achieving the right mix of assets to meet the risk and return needs of members at any particular age requires a level of built-in flexibility not always available with alternatives. So, for instance, a lifestyle arrangement may indeed reduce risks by switching into bonds in the crucial period before a member retires, but it remains quite a rigid structure. Making these or any other changes to asset allocations involves a cumbersome process of buying and selling funds within each individual member’s account. This can be confusing for members and makes it hard for the administrator to implement timely adjustments. More seriously, it can also result in very costly errors.
By contrast, a member in a TDF should only ever need one “fund for life”. All changes of assets, or indeed managers, happen within that fund, which means its geometry can be almost infinitely variable. The asset allocation “glide path” can be set to provide the best level of trade-off between risk and return at any given point in a member’s life. At the same time, the built-in flexibility means that the asset mix can be adjusted tactically to address changing markets, regulation and legislation. Moreover, because this is an open architecture approach, the best investment ideas can be chosen from wherever they exist. And of course, in this as in its other features, TDFs are agnostic as to whether the scheme is a contract- or a trust-based one.
So, by splitting the asset allocation from the oversight roles, while providing better risk-reward trade-offs across the age range, TDFs are indeed a major step forward in improving DC governance, whether it be in contract-based or trust-based arrangements.