A duty of care

Engaged Investor
May 2010

Governance and confidence go hand in hand

Good governance is fundamental in ensuring that employees feel more trusting and confident in their pension provision.

At the moment, however, standards and practice in governance are still geared to meeting the requirements of the defined benefit (DB) model. It is debatable if these practices fully meet the needs of the defined contribution (DC) world that is now so prevalent.

The National Association of Pension Funds (NAPF) has identified what it describes as 'a governance vacuum' around DC pensions in general, and highlights contract-based DC in particular. The Organisation for Economic Cooperation and Development has similarly highlighted that pension fund governance needs to be improved in order to avoid (unintended) over-exposure to risky assets.

So what are the issues that companies and trustees need to address in order to build DC governance structures and ensure their adaptability to evolving demands?

First and foremost, governance of investment and custody of DB schemes is not easily transferable to DC. Governance for DC must focus on helping members to effectively make their own decisions. More importantly, if members won't engage and are "defaulted", they need to ensure that the default structure is fit for purpose and employees understand the risks. Employees need to be supported if they are to achieve their future financial security.

Addressing the risks

The Pensions Regulator has identified several fundamental risks in contract DC governance: poor administrative practices; poor investment practices; high charges; poor decisions on retirement choices; and lack of member understanding.

Communications and investment strategies can form part of the answer. Employers have to keep engagement levels with members high, from the point of joining the scheme through to taking benefits. This is increasingly important in an era when flexible retirement practices will become the norm.

Members need to understand the risks they are taking on. They have to realise that different decisions on payment levels and fund choice will have different potential outcomes quality of living in retirement. Employers can help with this; targeting communications to influence behaviour without actually offering advice.

On the issue of investment, schemes are increasingly offering a wider range of investments, up to several hundred. (Previously, members frequently had minimal choice ). But excessive choice can paralyse decision-making. Currently, between 80 and 90 per cent of new savers in the UK fail to make a choice and their savings go into the default fund.

This presents a governance conundrum. The default fund has to be appropriate for the vast majority of scheme members regardless of their individual demographic and risk profiles. That's tough. Some schemes are pioneering the use of more sophisticated investment vehicles such as blended funds and target-date funds as possible replacements for the traditional, off-the-shelf lifestyle default funds. Others are looking at implementing a multi default fund approach.

Ultimately, though, it's down to management

The fundamental success of a DC scheme comes down to the commitment and buy-in of employers and trustees and the overriding precondition that someone takes decisions. Even there, however, there are problems.

Let's be clear. Setting up a contract based DC scheme does not absolve employers from a duty of care. There is a growing danger that employers have concerns about taking on additional risk, beyond the statutory minimum duty of care to provide automatic enrolment, adequate contributions and a default investment strategy. Instead of moving their benefit provision upstream, this could result in a 'dumbing down' in terms of quality of provision.

Large employers could press for some sort of Safe Harbour environment - a proven concept in the United States and Canada. According to the OECD these rules allow the employer to carry out due diligence in the choice and ongoing monitoring of service providers, investment alternatives and default options as well as helping to determine the nature and scope of the information and advice that is provided to members, while limiting liabilities.

Conclusion

Creating a 'safe harbour' for employers could have a positive knock-on effect. By freeing them from conservatism, caution or fear of prosecution, employers can be empowered to be proactive, highly involved and drive the communication, engagement and investment decisions that are needed to ensure a successful DC scheme.

Of course it could be argued that trust based arrangements already operate on this basis. It is possible that we will see more employers recognise the real advantages that a trust approach brings, in particular as greater levels of sophisticated DC models become the norm.

For a DC scheme to meet its objectives, it is not only members that need the comfort that their pensions are sheltered in this metaphorical 'safe harbour'. Sponsors need the freedom to take increasingly more technical decisions without the fear of repercussions. It happens in the US, so why not here too?