Defined contribution schemes: improving member investment choices

9 November

Many employers still provide defined benefit ("DB") schemes. However, the past two decades have seen a marked and growing trend towards defined contribution ("DC") schemes in the UK and with the introduction of auto-enrolment in 2012 it is a trend that is expected to accelerate. We also suspect that there may be a significant number of transfers from DB to DC schemes in the next eighteen months before the abolition of contracting out on a DC basis takes effect in April 2012.

This "spike" in transfers is due to the Government’s regulations implementing some of the detail relating to the abolition of contracting out on a DC basis. These Regulations are not in force yet. Unless there is a change in legislation and assuming the change takes effect in 2012, it will prevent any transfer from a contracted-out defined benefit scheme to a defined contribution scheme.

DC trustees and the role of improving investment choices of members
The Pensions Regulator ("Regulator") has stated that he expects trustees of DC schemes to improve the standards concerning pre-retirement processes and member communications and also that employers should engage responsibly with employees about pension arrangements. The Regulator hopes that if higher standards for DC pensions are attained, he proposes to impose a "minimal additional regulatory burden". The Regulator believes that it is more important than ever in the current economic climate for members to make the "correct" decisions to maximise value for money at their retirement. The "Myners’ Principles" have improved investment decision-making and governance for trust-based schemes. However, there is a gap on what amounts to "best practice" guidance relating to the investment governance of DC schemes. This note focuses on this key issue.

Is the range of fund options adequate?
Investment options should take account of a range of member risk profiles and needs. The options available to members should be designed appropriately to take account of this point. DC members need to be able to access a range of fund choices. The range of fund choices needs to strike the right balance between meeting member needs, but without being overwhelming or restrictive.

Is there any practical guidance on how this can be done?
Guidance has been expected from the Department of Work & Pensions for some time but to date, nothing has published. The Regulator’s "Investment Management Group" ("IMG") has provided some practical suggestions on what constituted good practice in DC schemes investment policy. In the Regulator’s publication entitled: "Principles for investment governance of work-based DC pension schemes", the IMG stated that trustees should:

• consider the number of funds (as components of the investment options or as standalone entities) to be made available and how the number on offer might impact the ability of members to make effective investment decisions;
• offer an adequate range of investment options given the expected risk tolerances and requirements of scheme members, including the likely format and structure of their retirement benefits, and consider how these options may change as they approach retirement;
• consider;
  
  
• the way investment options are classified and described with a view to making it easier for members to make appropriate choices (eg through the use of a core fund range or listing funds by risk rating of asset type);
• the operational characteristics of funds including dealing frequency and liquidity;
• the costs, including management fees and other fund expenses;
• the security and stability of the firm(s) providing investment management services and products;

• ensure that the investment options/funds offered have appropriate names, clear investment objectives and relevant benchmarks;
• ensure that investment fees/costs are reasonable and competitive given the performance expectations of the fund;

What about default strategy options?
The suggestions also state that trustees should offer an appropriate default strategy when a member fails to make up his or her own mind about which fund(s) they will invest in. The default strategy should:

• allow appropriate time for design, review and monitoring of the default strategy as compared with other investment options;
• ensure there are clearly defined strategic objectives for the default strategy in terms of the levels of risk and returns inherent in achieving the desired outcomes for members;
• ensure the membership data on which the default strategy is based is as robust and detailed as is practical;
• ensure the design of an appropriate default strategy considers, as far as is possible, the needs of the broad membership, including:
• risk and return (net of fees/costs);
• its position in relation to all other investment options;
• members’ expected term to retirement;
• members’ attitude to risk;
• the expected format and structure of their retirement benefits;
• ensure that investment fees/costs are reasonable and competitive given the performance expectations of the strategy.

"Looking after your DC plan: A good practice guide for employers"

Further information from the Regulator is entitled: "Looking after your DC plan: A good practice guide for employers".

This guidance was published earlier this month and includes the six revised DC overriding principles, which state that trustees should have:

• clear roles and responsibilities – aiming to help ensure that firm foundations are in place for the process of investment governance;
• affective decision-making – decisions relating to investment governance must be taken on a fully informed basis and that the processes must be sound;
• appropriate investment options – to make certain that investment options take account of the range of risks and needs within the scheme membership;
• appropriate default strategy – determining that an appropriately designed investment strategy is offered for members who prefer not to make a choice;
• effective performance assessment – the performance of the chosen investment options must be monitored;
• clear and relevant communication – to ensure that members are provided with clear, relevant and timely information so they can make an informed choice about where to invest.