DC pensions issues being overlooked as trustees focus on sorting out DB
by Dr. Ros Altmann
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The UK pensions landscape is currently undergoing a seismic shift. Employer provision is moving from traditional defined benefit (DB) schemes to defined contribution (DC) arrangements. Most DB plans are closed to new members and will probably soon close to new accruals. The striking things is, however, that although future company pensions will be DC, most of the new thinking and time devoted to pension issues is addressing the old DB problems, rather than ensuring new DC schemes work well.
There is a worrying ‘governance gap’ here. After all, every type of pension fund surely has the same ultimate aim – delivering good pensions to members. DB trustees are realising the need for liability-focussed investment approaches, to meet expected long-term pension payments, however, there is little sign of this in the DC environment, even in trust-based schemes. A recent Hewitt survey showed most DC schemes have no business plan, around 40% do not evaluate their effectiveness at all and only 20% use formal measurement approaches. There is also little evidence of any proper governance framework for DC investment decisions.
The Pensions Act 2004 imposed new burdens on employers and trustees. However, recent radical thinking on modernising investment approaches and controlling downside risks, is occurring in DB schemes, while the implications for DC have not been carefully considered. This may be because DB deficit problems are potentially life-threatening to employers, most assets are in DB, or the risk of inadequate DC pensions falls on members, rather than employers, so perhaps DC trustees feel less urgency. However, none of these are acceptable reasons and one is left questioning whether DC trustees have fully recognised their new legal responsibilities. Indeed, even DB scheme trustees probably need to address such issues for any AVC arrangements they have in place.
So what areas must DC governance address? The ultimate value of DC pensions depends critically on several factors. Apart from the annuity rates at retirement (trustees must focus more on ensuring members have access to the most appropriate annuity options or advice for their circumstances) the level of contributions is obviously a key factor. ONS figures show average DB contributions in 2004 were 18.8% of salary (employers 14.5%, employees 4.3%), compared with just 8.9% (6% employers, 2.9% employees) for DC. Are trustees helping members understand the implications of this, or providing assistance in planning appropriate contribution levels for delivering desired future pensions?
Charges are important too. Administration charges should be minimised, but investment management costs are increasingly important. With-profits and managed fund fees have been creeping up, which will damage future returns. For example, paying 1.5% rather than 0.5% per annum, could reduce the value of a £49,000 fund over 30 years by £82,000.
Naturally, investment options offered are particularly critical. Myners focussed on the suitability of investment funds as a key issue, which is still not receiving enough attention. Liability-driven investing, inflation-hedging, moving away from over-reliance on long-only equities, considering alternative assets, absolute return approaches and downside risk control are becoming common in DB, but are not feeding into the DC area. Both DB and DC arrangements are trying to deliver pensions, just in different ways. Both must cope with inflation, duration and longevity risks, to be able to deliver good pensions in the long-term. Both need reliable sources of return and risk control. If traditional investment approaches need altering for DB schemes, does this not also apply to schemes where employees bear the pension risks? However, most DC investments still follow the traditional DB approach – relying heavily on equities – without making use of new techniques and broader diversification.
Although many DC schemes are now offering more investment choice, using fund-of-funds and external managers, their default options – selected by around 90% of members – are still quite unsophisticated. ‘Lifestyle’, unit-linked managed, balanced funds or perhaps with-profits are the norm. These cannot be suitable for all members. More targeted default options could be developed, catering for people with differing circumstances, differing risk preferences, and particularly funds offering inflation- and capital-protection. Investors unfamiliar with investment markets usually prefer capital appreciation or preservation, to outperforming index benchmarks. Balanced funds still lose money in a bear market and members need to understand this, or be given the chance to protect themselves.
In summary, there is a worrying lack of focus on DC governance. Trustees must recognise their new responsibilities with DC arrangements, not just DB, covering investment options and member education. Members need help with financial planning, to assess sensible contribution levels for achieving a desired pension. Trustees and members must also understand the impact of forthcoming A-day changes. Even if companies are moving from trust-based, to contract-based arrangements (such as stakeholder or Group Personal Pensions) there are still important investment and education issues to be addressed, to help DC schemes deliver decent pensions in future.