Pensions World

Will Aitken, Towers Watson, on the government’s proposals to increase governance requirements for contract based schemes

Next year, auto-enrolment into defined contribution (DC) pension arrangements will start in earnest. Research indicates that where auto-enrolment occurs, rates of investment defaulting can be as high as 90%. Consequently, quite soon, large swathes of the population will find themselves with money invested in assets they did not choose for themselves. 

On 13 December 2010, the Department for Work and Pensions (DWP) issued a consultation document seeking views on its proposed guidance for the design of default investment options. The proposed guidance is intended to apply to both occupational and contract based DC arrangements. This is effectively the first time that some form of governance has been mandated for contract based schemes. Until now, employers operating contract based schemes could rely on providers to worry about investment options, including the default. That may no longer be the case.

Suitable approach?

One crucial requirement is to specify who has responsibility for governance aspects of the default option. Those aspects include designing a suitable default option, monitoring the default fund’s performance, communicating with members and regularly reviewing the option. In a trust based environment, these roles fall on trustees. 

In a contract arrangement, the position is less clear. A starting point might be for all roles to be fulfilled by the provider. But can a provider really nominate a default investment that “takes account of the characteristics and needs of employees who will be automatically enrolled into it”? That might mean a provider designed default as suitable for seasonal retail staff as it is to investment bankers. Can that be achieved? Nest has itself decided that for lower earners, a low risk lifestyling approach is best. Is that suitable for employees from all walks of life? If providers take on a large scheme, shouldn’t that population influence the design of the default and then, by extension, the default for all the provider’s other policyholders? It is an approach that seems inherently flawed.

If a standard provider default is unworkable, employers themselves might need to design default investment options, potentially moving governance of contract based schemes much closer to that of trust based schemes.

Best practice

Another proposal of the consultation document is that the default option should be reviewed at least every three years and should be monitored at regular intervals throughout the year. This seems to be mandating triennial reviews of defaults and to require that someone monitors the option at least twice a year. In both cases, this is established good practice for many schemes, but it introduces a level of governance for many contract based schemes that does not currently exist.

So how will members learn about the default and any reviews? The proposed guidance is clear – information on the default option should be communicated to members regularly, particularly following a review and as a member nears retirement. So, as a minimum, every three years employers will need to communicate in a clear manner which the membership can understand, and as members approach retirement, they may need to be communicated with more frequently. Again, this is established best practice for many companies and trustees, but will be completely new territory for many employers with contract based DC schemes.

Affordability

In relation to affordability, the proposed guidance says that “The default option should be appropriately and competitively priced” but what constitutes “competitive”? Nest? Is a default in a commission paying arrangement appropriate and competitive compared to an otherwise identical nil commission counterpart? If a provider level default is nominated, can it genuinely be appropriately and competitively priced if different charges apply to differently sized schemes?

And what are the implications for those employers that do not want to engage, given that the DWP is only proposing guidance? Adherence to this will be monitored and regulatory steps taken at a later date if necessary.

Occupational scheme compliance will fall under the Pensions Regulator’s remit. It will no longer be possible to set up a contract based scheme and walk away.

Will Aitken is a senior DC consultant at Towers Watson; will.aitken@towerswatson.com