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OPDU
Report 27 June 2010 - Annual Risk Conference Special Edition
What can go wrong? DC Case Study - Administration:
Defined Contributions – mostly harmless?
John Reeve, Senior Consultant, Premier Pensions Management
Limited
“Space is big. Really big. You just
won’t believe how vastly hugely mind-bogglingly big it is. I mean
you may think it’s a long way down the road to the chemist, but
that’s just peanuts to space.”
These are the first words in the Introduction of the “Hitch
Hikers Guide to the Galaxy” made famous in Douglas Adam’s five book
“trilogy” of the same name. Adams goes on to show us that space is
not only big it is also full of risks and dangers for his “hero”,
Arthur Dent. Dangers such as spaceships programmed to crash into a
sun, infinite improbability drives and Vogon poetry not to mention
the Total Perspective Vortex.
Like the Earth in Adam’s book, destroyed to make way for a “hyperspacial
express route”, we are rapidly approaching the time when Defined
Benefit schemes will be destroyed. Arthur Dent was forced to
undertake a dangerous journey through time and space. Similarly we
will soon all be navigating our way through the dangerous Defined
Contribution (DC) void.
The DC journey is a risky one for any member and, in the case of
a Trust based DC Scheme, any risk for the member is a risk for the Trustees.
So what are the risks faced by members and thereby Trustees in
their journey through the DC maze? This article looks at some of
them and at the questions that Trustees should be asking themselves
and their advisors.
Fund Choice
First the launch. Arthur Dent hitched a lift on a ship of the
Vogon Constructor Fleet with the help of his friend Ford Prefect
from a small planet somewhere in the vicinity of Betelgeuse. Our DC
members don’t have such help. They have to rely on the Trustees or
fend for themselves. We know that over 90% of all members fail to
make a positive decision with regard to their investments and end up
investing in the default fund. But, by definition, the default
cannot be applicable to 90% of members. Whilst investing in the
default may represent a risk for the member, it also
represents a risk for the Trustees. The Trustees will select the
default in the first place and they have a responsibility for
ensuring that it continues to be appropriate as circumstances,
markets and the demography of the membership alters. What happens
if the default fund does not perform well?
How many Trustees regularly review the default? How many really
understand the risk appetite of their members? How many can really
show that they have done everything that they can to ensure that the
default remains appropriate? Indeed how many have questioned the
typical lifestyle funds which have recently sold equities at the
bottom of the market and forced members to buy gilts at a time when
most commentators would suggest that they are very expensive?
The choice of the default is one of the most important decisions
that a DC Trustee makes and it is one which must be continuously
monitored. Inappropriate defaults or a failure to monitor and manage
the default could leave Trustees exposed to complaints from members.
The issues with defaults often lead Trustees to ensure that
members have a vast choice of other funds. This, they argue, is the
best approach for members since it means that the Trustees cannot be
accused of not offering a fund which, with the benefit of hindsight,
is seen to perform the best. But nothing could be further from the
truth. An increasing body of research from behavioural finance
academics shows that increasing the choice to members makes them
less likely to select any fund and will increase the number who do
not join or who fall into the default fund.
Thus, Trustees should select the investment choices carefully.
They should select the default with even greater care and they
should continuously monitor the options provided – changing them
where necessary.
Contribution Levels
To travel through space Arthur and Ford use the Infinite
Improbability Drive, powered I believe by a really hot cup of tea!
Our members select the level of contributions to power them to a
safe and comfortable retirement. One might argue that Trustees can
do no more than to provide members with the information that they
need to make the decision. However, Trustees of final salary schemes
have faced the challenge of getting more money from sponsoring
employers as longevity improves and investment returns fall. The
same factors apply to DC Scheme members. Those who started
contributing several years ago with a target pension in mind will be
as “underfunded” as most DB Schemes.
What is the role of Trustees in ensuring that members pay the
appropriate level of contributions or that they understand the level
of pension that their selected contributions will provide? How many
Trustees have advised their members to increase contributions to
reflect the increasing cost of annuities? Could Trustees be
considered to be failing members by not explaining these issues to
them?
Operational Issues
So far we have talked about default funds and about the level of
contributions. These are all things that members can do something
about but commonly do not. It is a moot point as to whether these
are issues for the Trustees. However what is undoubtedly their
responsibility is the effective and efficient operation of the
scheme. Many trust based DC arrangements were established in the
shadow of a larger DB brother. Thus the same operational processes
were adopted. In many cases this means that DC contributions are
remitted alongside the DB contributions on or around the 19th of the
month following deduction. However it only takes a moment to realise
that this is inappropriate. Contributions deducted from the members’
salary are often not remitted to the Scheme until 3 or 4 weeks
later. Thus members are often missing out on up to a month of
investment returns. In a market which has seen large volatility it
is obvious that this is not something that can be tolerated. Whilst
the move towards the introduction of Straight Through Processing
(STP) is to be welcomed, quick investment of contributions is not
enough if the money is not sent until 4 weeks too late.
“The first ten million years were the worst,” said Marvin, “and the second ten million years, they were the worst too. The third ten million years I didn’t enjoy at all. After that I went into a bit of a decline.”
“Decumulation”
In the Hitchhikers Guide Marvin, the paranoid android, spent
several million years parking cars at the Restaurant at the end of
the Universe “The first ten million years were the worst,” said
Marvin, “and the second ten million years, they were the worst too.
The third ten million years I didn't enjoy at all. After that I went
into a bit of a decline.” His pension provider would have been even
more depressed by the longevity that he showed although since he was
still parking cars one has to assume that he did not make adequate
provision for his long retirement years. As interest rates fall and
as we are living longer, the importance of selecting the right
annuity becomes even more important. Even if the member has made
exactly the right choices prior to retirement and accumulated a
significant pot of money through his or her career he or she can
still lose up to 20% through the poor selection of the annuity
provider.
The Regulator has expressed its concern regarding the lack of
advice provided to members on their options at retirement. It has
proposed that Trustees should provide members with access to
independent advice as to their options in relation to “decumulation”.
Trustees have a duty to ensure that members have every opportunity
to make the right choices. This include not just helping them to
select a competitive provider but also to take advantage of
impaired life annuities, income drawdown and other specialist
options where appropriate.
Trustees’ Roles and Risks
We all know that DC schemes have shown themselves to be more
complex in terms of administration and communication than DB
schemes. However, until recently, I think it was commonly felt that
the role of the Trustee is simpler for a DC Scheme. However, I have
recently seen it argued that, whilst DB Trustees are merely there to
see that the benefits promised to the member are delivered, Trustees
of DC Schemes can make a real difference to the benefits that
members get in retirement; for better or for worse. Unless the
sponsoring employer becomes insolvent then DB Trustees will merely
oversee the delivery of defined benefits. Arguably, their DC
equivalents have a real opportunity to ensure that members
understand their arrangements and make the appropriate level of
savings in the appropriate investments and hence have the best
possible level of income in retirement. However, with opportunity
comes risk. With the additional responsibilities that the DC Trustee
can find him or herself accepting, there is the possibility of
getting it wrong. The fear of getting it wrong has meant that some
Trustees have avoided dealing with the issues but an accusation of
“guilt by omission” may still be levelled at their door.
The Future
We are only at the start of the process in respect of members
taking action against Trustees for failures in respect of these
matters. Only now are we beginning to see members retiring with
significant accumulated DC assets or with the majority of their
pension savings coming from their DC arrangement. It is therefore
only now that we are beginning to see members asking:
- Why were they put into that particular
default fund and automatically then had their
investments switched at that particular time?
- Why were they not warned of the
need to invest more given the increasing cost of annuities?
- Why was
their money not invested more quickly once it was deducted from their pay?
- Why were
they sold an annuity paying 20% less than other
providers were offering?
Whether Trustees really have duties in all of these areas is a
matter of doubt. What is not in doubt is the fact that someone
should be helping members avoid the pitfalls that are described here
and Trustees are at the vanguard.
Arthur Dent makes sense of the strange worlds he travels through
with the help of the Babel fish which translates all alien languages
for him. In the absence of our own pensions Babel fish which will
help members understand their DC Scheme, the role of Trustees and
Scheme sponsors is vital. Failure to meet the challenges will leave
members with lower benefits and Trustees and sponsors exposed to
criticism. Successfully meeting the challenges could lead to
Trustees having a real and positive effect on the welfare of
pensioners in the future.
John Reeve
Senior Consultant
Premier Pensions Management
020 8663 5800
information@premierpensions.co.uk
www.premierpensions.co.uk
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