Keeping an eye on you

EI MarApr07 p13-15
21/3/07
15:54
Page 13
Want to offer better investments? Worried about communication?
Then visit: www.engaged-investor.com and download previous
DC Focus articles
DEFINED CONTRIBUTION FOCUS: DC REGULATIONS
Keeping
an EYE on you
A specific regulatory
framework for defined
contribution schemes
is on the horizon.
Robert Melia Watson
finds out what shape
trustees believe this
should take
Illustration by MARK TIMMINS
t has been a long time coming, but
the Pensions Regulator is gearing up
to announce the way it intends to
supervise define contribution pension
schemes. Touted as one of its main
areas of focus in the three-year business
plan it unveiled last year, the watchdog has
identified five main areas of risk on which the
eventual regulatory framework it builds will
centre. These are poor administrative
practices, poor investment practices, unduly
high charges, poor decisions on retirement
choices and lack of member understanding.
I
But the Regulator says it isn’t not after
establishing itself as Big Brother figure and has
consulted informally with schemes, consultants
and trade bodies in the pensions industry.
Everyone agrees some form of controls are
necessary as there are already far more DC
schemes than DB plans, but they are varied and
being less regulated, members, who practically
ENGAGED INVESTOR
assume all the risk, have no guarantees over the
pension their investments in a DC scheme will
eventually provide. “We are not just a DB
regulator as 85% of all UK pension schemes are
TRUSTEES WANT TO SEE
■ DC regulation building on foundation
of administration and communication
as basics
■ Trustees taking more responsibility to
help members manage risk
■ Better protection for investment funds
■ Investments monitored more
effectively and efficiently
■ A light and balanced regulatory
regime that encourages firms to set up
DC schemes, not scare them off
small DC schemes,” says Tony Hobman,
chief executive of the Regulator. “Our aim
is to apply reasonable judgement to
innovation.”
Many in the industry believe the best
way to ensure members get the best possible deal
is under the watchful eye of trustees. They have
experience of running a scheme and many have
been very busy recently brushing up on the
investment knowledge and governance skills. But
companies have a choice and contract-based
schemes which do not have trustees are a
cheaper option. So what do trustees believe is the
best way to regulate DC?
GET THE BALANCE RIGHT
Penny Green, chief executive of the University of
London’s scheme’s trustees believes getting the
right balance is essential. “The risk of introducing
regulations fortrust based DC is that it will
➔
drive employers away from trust DC into
MARCH/APRIL 2007
13
EI MarApr07 p13-15
21/3/07
16:10
Page 14
DC FOCUS: DC REGULATIONS
➔ contract DC,” she comments. “But there
does need to be some way of bringing DC
trusteeship up to scratch and so whilst I accept
the need for
regulation I think it does need to be a light touch
if the Regulator really wants trust-based schemes
to survive and even thrive,” she adds.
Prominent Prudential trustee, Pete Davis,
believes the Regulator should take a look at the
way the various parties involved in providing DC
pensions interact. “I’m not persuaded that
trustees or employers can merely hand everything
to an insurer and rely broadly on Financial
Services Authority’s principle that the insurer
must treat its customers fairly,” he warns.
...there need to be some way of
bringing DC trusteeship
up to scratch...
“
RISKY BUSINESS
Davis also believes that if the Regulator is basing
its DC supervision on risk, then it must enforce
the idea that trustees and the sponsoring
company burden some of the risk. And trustees
need to take the role more seriously. “Although
members bear all the investment and longevity
risk, the trustees should concern themselves with
these risks just as much as they do for DB.
Trustees ought to imagine a future in which
members’ investments have performed badly and
in which life expectancy has continued to
increase. They and their sponsor will be facing
”
complaints from dissatisfied retiring members
and claims for compensation. The trustees need
to ask themselves what they need to do now. Not
only in the eyes of the Regulator and the scheme
lawyer, but in the sense of having no moral
qualms about it.” he says.
As far as regulating the DC trustee role, Davis
believes the Regulator should consider the basics.
This means trustees need to make sure that the
sponsor pays the contributions on time, that the
administration is sufficiently well-established so
that contributions are allocated to members’
accounts efficiently, and that withdrawals especially on retirement - are
also handled efficiently.
TAKING THE LEAD
Another trustee at a
leading UK firm believes
protecting investments is
paramount and trustees
should guide their members
throughout the life of their
pension more closely. “Suitable safeguards should
be in place for DC. Funds should be ring-fenced
for individuals and linked to an approved life-cycle
investment plan. Regular reviews should take
place to ensure that members receive forecasts of
their future pension,” he says.
Jim Osbourne, a trustee at Allianz Cornhill
agrees and firmly believes all DC schemes should
be trust-based, with trustees having to take greater
responsibility for helping members manage their
risk. “DC supervision needs to focus on governance
with DC schemes being looked after by trustees.
There is a real need for improved communication
between trustees and DC members,” he says. In
addition, he feels trustees must start delivering
better scheme member financial awareness and
understanding of how DC works. They should
explain better the various investment approaches
used for DC schemes and trustees must have a
clear duty to monitor the investment performance
of funds which members invest in. “Members are
not sophisticated enough to do this and trustees
have a key role in doing that,” he warns.
Many in the investment management industry
believe it is time to review the way trustees
monitor DC investments and they must adopt a
different attitude from the way they monitor DB
investments. This particularly refers to monitoring
the length of time from a contribution being
A few home truths
Andrew Cheseldine of Hewitt Financial Services points out there is already plenty of DC regulation out there
and effective governance may always depend on size
here is already a plethora of regulation controlling the provision of defined contribution (DC) pensions in the UK. Apart from
the various Pensions Acts, Revenue & Customs
regulations on simplification, EU driven legislation on anti-discrimination and TUPE (which,
unhelpfully, is different for trust and contract based
DC plans), we have “guidance” from The Pensions Regulator.
In fact the scope guidance for trustees of DC
arrangements includes nine main units: trust law,
pension law, investment, funding, investment
choices, fund management, understanding the
scheme’s trust deed and rules, statement of investment principles, other relevant scheme documents, all of which are expanded into their detailed
expectations of trustees
On top of this, the Regulator has recently added
a consultation paper on the regulation of DC. The
paper considers the key risks it believes are most
common across DC schemes: poor administration, poor investment practices, unduly high
charges, poor decisions on retirement choices,
and lack of member understanding.
T
14 MARCH/APRIL 2007
Although it is difficult to argue with the premise behind the first three of these, one problem
with the latter two issues is that they are common in all DC environments throughout the world
and regulation is unlikely to overcome them on
its own. Indeed, there is a serious danger that
imprecise legislation could be counter-productive.
Part of the problem with regulation is that
schemes with the largest numbers of members
are mostly well run already. Given their sheer size,
trustees and/or plan sponsors are keen to focus
on their general effectiveness including mitigation
of strategic risks, via best practice rather than
simple regulatory compliance. However, these are
also organisations where overly onerous compliance regimes could easily lead to regulatory arbitrage. In other words, if the regulations load too
many requirements onto trust based schemes,
employers could easily just switch to contractbased plans.
At the other end of the scale, smaller plans do
not have the resources to dedicate to scheme governance and, therefore, aim for the minimum necessary for compliance – if that. These organisations
often do not even know that there is a shortfall
in governance procedures. They rarely employ
advisers because of cost constraints and, unfortunately, the commission based sales team who
implemented the plan are often conspicuous by
their absence some years down the line.
So where can we go from here?
First, we should accept that smaller employers
will rarely be able to fully resource the governance
requirements of trust arrangements. So rules must
be in place to ensure “conveyor belt” governance
at source. Second, we must recognise that larger employers, who are concerned with both best
practice and quality in trust based DC provision,
should not be disincentivised by having additional
layers of rules imposed on them for little or no
actual increase in member security or benefit. ■
ENGAGED INVESTOR
EI MarApr07 p13-15
21/3/07
15:55
Page 15
DC FOCUS: DC REGULATIONS
deducted from
salary to actually
being invested in a fund. In a DB
scheme, if there is a delay in
investment it doesn’t impact on the
individual member’s benefit. In a DC
scheme it could have a material effect.
A WHOLE NEW WORLD
The Regulator itself says it expects
trustees running DB schemes who
are asked to set up a DC section to
fully understand the diffferences
between DC and DB. “We are very
keen to make sure that those trustees
who may have a DB background
don’t get complacent about a DC
scheme,” said Alistair Elliott, the
watchdog’s technical specialist.
Quality not quantity will also be a
key feature of DC supervision,
especially when reviewing operations
and business contracts with
providers. “What we are keen to
explore more – which may lead to
guidance – is that service level
agreements tend to focus on quantity,
for example, how many requests have
you had, and how quickly were they
turned around, without necessarily
looking at quality, or how well issues
have been dealt with and how closely
standards in service level agreements
are monitored,” Elliot continues.
NO STONE UNTURNED
There is some concern that there are
loose ends in DC provision that could
make enforcing regulations tricky. For
example, third-party administrators
are not themselves directly regulated,
but Elliott says the Regulator is on
top of this.
“Some people might say there is a
regulatory black hole there, but we
can take action if circumstances
warrant it,” he claims. “If we are not
happy with the behaviour of any
party, not just trustees, involved in
running a pension scheme and there
is a breach of pensions legislation,
we can issue improvement notices.”
A CLEAR MESSAGE
The Regulator wants to make sure
the message coming out of the
consultation is that trustees need to
have the right processes in place.
“What we expect to be emphasising
is that it is key to have appropriate
processes. This will initially look at the
actual needs of the employee base the
scheme is going to be looking after,
because not every group of employees
is the same,” Elliott begins. “One
employer may have quite a financially
sophisticated group of members,
while other employees are less
financially sophisticated, so the range
of investment funds could be very
different between the two groups.
Overall, monitoring how the scheme is
working in practice is important.
Talking about processes sounds a bit
dry but we cannot present a case
study as the answer for all trustees
because every employer and every
scheme is different.” he continues. ■
TAKING IT FURTHER – ENFORCING REGULATIONS
Policing DC regulation to a
large degree will rely on
whistleblowers. This builds
on the way the Regulator
enforces DB supervision.
Indeed, the existing code of
practice about breaches of
the law applies as much to
DC schemes as it does to DB
funds. This means it expects
anyone involved in the
scheme, be it the trustees,
pensions manager, third-party
administrator, consultants,
auditors and even the
members to report any
breach of the rules or law. Or
at least warn the Regulator
that they suspect something
is amiss.
“What gives us some
reassurance is that running a
pension scheme usually
involves a number of different
ENGAGED INVESTOR
parties and it’s likely that one
of those professional parties
will become aware of a
problem,” says the
Regulator’s technical expert,
Alistair Elliot.
“If they can’t resolve the
issue internally within the
scheme, which is always our
preferred route, then they are
required to draw it to our
attention in the report of
breaches code.”
A system of self-regulation
might be another possibility,
says Gary Smith, senior DC
consultant at Watson Wyatt.
“The alternative is to ask
people to come back to the
Regulator to certify they are
doing A, B and C, which is
perhaps a stronger approach
and more likely to get a
reaction,” he adds.
EXPERT VIEW
REGULATING RISK –
UNINTENDED CONSEQUENCES
Ian Richards, head of DC strategy at Legal & General
Investment Management, wonders if some risks haven’t
been overlooked
While few
will disagree
with the five
risks that the
Pensions
Regulator
has identified, many
might question whether
regulation is
the best way to mitigate their effect
without adding a sixth risk – that of
leading employers into reducing
their commitment to pensions.
The law of unintended
consequences is certainly lurking.
Many employers have switched
from defined benefit schemes in
order to secure greater control of
future costs and to relieve some of
the burden of running a scheme,
taking the opportunity to reduce
their contribution level which has
to be a warning sign that they do
not necessarily see pensions as
giving the best value for money in
their spend on benefits and
compensation. If employees have
to be educated, encouraged or
even cajoled through autoenrolment into an arrangement
set up for their benefit, it is
difficult to argue that providing
pensions has the recruitment and
retention power it once had.
The Regulator’s DC risk
consultation paper has to be seen
against this background and it is
not going to be helpful if
employers find that they are going
to have to bare extra expense on
yet more communication and
education, and improving controls
in payroll and accounts. The
danger is employers will look to
reduce contributions further or get
out when they can, such as when
Personal Accounts are introduced.
A balance has to be struck as a
poorly
run
scheme
with
reasonable contributions is still
likely to be better than a low
contribution scheme or no scheme
for the majority of members. The
successive gold plating of the
benefits that employers of DB
schemes have been forced to
provide has been a factor leading
to their demise. There is a danger
that this could be the start of a
similar journey for DC.
Trustees may need to start
looking at their scheme slightly
differently. If there is a risk that
employers will become less
supportive, they may have to
adopt a similar attitude to that of
the trustees of DB schemes to
strike a balance between
protecting members and not
pushing the employer towards
closing the scheme or bankruptcy.
They should be reasonably
cautious in their requests for the
employer to pay for promotion and
education to increase take-up, if
that is likely to create cost issues.
They also need to look at the
impact of early leavers. Few
employees are likely to remain in
the same employment all their
working life which means that, over
time, most DC schemes will be
building up a substantial number of
deferred members that will need to
be serviced at a cost similar to that
of active members. This will be a
cost burden that few employers will
be comfortable with.
In conclusion, if unintended
consequences are to be minimised
as a result of extra regulation,
trustees are going to have to think
more widely than just meeting
basic requirements. ■
MARCH/APRIL 2007 15