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The trm Report - May 2007 What makes a Good DC Scheme? Many employers now offer their employees pension provision via some form of defined contribution (DC) arrangement. This may be alongside a defined benefit (DB) scheme, perhaps closed to new members, or it may be the main form of provision for current employees. Much of the debate around the switch from DB to DC has been conducted along the lines that DB is good and DC is bad. That is clearly too simplistic and a more appropriate question is to ask, what makes a good DC scheme? Good governance is crucial for any pension scheme. It is important that the scheme is efficiently managed and meets the needs and expectations of the sponsor and of the scheme members. For corporate sponsors and pension scheme trustees familiar with DB schemes, an important issue is to understand the similarities and differences between effective governance of DB and DC schemes. DC schemes put the investment risk of saving for retirement onto individual members, while typically giving them some control over how the pension contributions are invested. However, this transfer of risk and responsibility does not mean that effective management of the DC scheme is a trivial task from the employer or trustees’ point of view. From the employee’s perspective, there are four main decisions to make in relation to a DC scheme
While these decisions are ultimately in the hands of the individual scheme member or employee, evidence suggests that scheme design can have a significant impact on the choices they make, for good or for bad. It is important for trustees and corporate sponsors of DC schemes to consider carefully how members may perceive and respond to the arrangements in their scheme. For example:
Investment presents one of the major challenges in DC:
Most scheme members are not particularly comfortable with investment issues and relatively few receive individual advice. As with DB, asset allocation is a key determinant of the investment outcome. Members need a growth strategy that will help them accumulate assets through their period of membership, but need to be careful to manage risk as retirement draws nearer. Lifestyle funds that switch from equities to bonds as the planned retirement date nears are a commonly used ‘auto-pilot’ approach to this problem but they are increasingly being described as ‘blunt instruments’. A key difference between DB and DC relates to the available form of governance. DB schemes operate under trust law, where the trustees are responsible for acting in the interests of members. Many DC schemes, especially large ones, also operate under trust and the trustees bear much the same responsibilities as in DB. However, a growing number of employees are opting for ‘contract-based’ DC schemes such as Group Personal Pensions (GPPs). In these schemes, the main relationship is between the pension provider - an insurance company - and the individual members. The relationship is governed by financial services regulation. However the employer typically chooses the provider and may play a role in shaping the menus of choices that their employees face. A key responsibility for the employer is in reviewing the ongoing suitability of the arrangements for their employees. While most employers will be keen to ensure their DC schemes are well designed and well managed in order to maximise the chances of their employees enjoying comfortable retirement incomes, there are also important considerations about reducing the risk to the company of liabilities as a result of the DC scheme failing to live up to reasonable expectations. A well designed scheme with appropriate governance arrangements will stand a better chance of meeting expectations and allows the employer to show ‘due diligence’ in the event that investment performance or other circumstances lead to members being disappointed. Alistair Byrne |
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