David Blake, director of the Pensions Institute at City University’s Cass Business School, assesses contract-based DC pensions investment as 2012’s reforms approach. Jenny Keefe reports
Contract-based defined contribution (DC) pension schemes are the pensions equivalent of Ugg boots – they are loved and loathed in equal measure. In the UK, DC schemes are managed in two ways. They are either trust-based, where the employer provides a trust to represent employees’ interests, or contract-based, where employees deal directly with the pensions provider and make their own investment decisions.
Contract-based schemes are cheap and easy to run, but many believe they have a downside because there are no trustees to protect members’ interests. David Blake, director of the Pensions Institute at City University’s Cass Business School, says: “The most important issue with contract-based DC pensions relates to governance. †Trust-based schemes have a trustee board, which does all the due diligence work on key aspects of scheme design.
“Trustees pick appropriate minimum contribution rates and decide the range of retirement income options. They make asset allocation decisions, deciding how much will be in equities and how much in cash, and they choose the specialist investment advisers to carry it all out. Contract-based schemes do not have a board of trustees to provide such good governance.
“There is just the general impression that the default investment funds are not well designed to achieve their required purpose: a good-value retirement income for money that has been invested for so long.”
Trustees not investment advisers
Of course, trustees, many of whom are employees, are not investment advisers. This raises the question of whether it would be better for staff to save on administration fees and just give the cash to an insurance company to manage through a contract based scheme. “If significant contributions from both employer and employee are going to be invested over 40 years, then it pays to get an appropriate, dynamic investment policy in place,” says Blake.
He concedes that “trustees do not have the skills to do this”, and says it is worth appointing a good investment consultant.
When choosing between trust- and contract-based schemes, much depends on an organisation’s size, says Blake. “Small employers with low governance budgets will find it easier to hand the contributions over to an insurance company, especially if employees are not sufficiently interested to become trustees. It is this situation the National Employment Savings Trust (Nest) [formerly known as personal accounts] is intended to deal with.
“Larger employers with a workforce more interested in pensions might go down the trust-based route. The future, however, could be Nest for small employers and trust-based DC schemes for larger employers.”
Nest is due to be introduced in 2012 as part of the government’s pension reforms, which will also see the introduction of auto-enrolment, and compulsory employer and staff contributions.
Feeling the economic pinch
Like other investments, contract-based schemes are still feeling the economic pinch. “Very few investment assets have done well in the recession,” says Blake. “Equities led the way with falls of more than 25%. Yet, where the default fund in a contract-based scheme was an insurance company’s managed fund, which, typically, has a significant holding in bonds, this might have fallen less than funds with heavier equity weightings. But where the managed fund had a large holding in bank bonds, these would have performed badly, too.”
Some employers have encountered criticism that they have used the absence of trustees to cut their contribution rates to contract-based schemes. But Blake has not seen any evidence of this. “It is more likely that employer contributions were not that high in the first place,” he says. “Employers do not currently have to contribute to stakeholder pension schemes.”
Governance is not the only issue bothering Blake. “There is also the general impression that, with contract DC schemes, everything is commission-driven on the part of providers,” he says.
New FSA rules
But new rules proposed by the Financial Services Authority (FSA) could knock such practices into shape. The FSA’s Retail Distribution Review, published in December last year, could mean consultants and advisers will no longer be able to cash in on commission from sales of group personal pensions (GPP), stakeholder pensions or group self-invested personal pensions (Sipps). The new rules will come into effect by the end of 2012.
“The FSA is proposing to end commission and replace it with fees for advice,” says Blake. “It is likely the greater transparency this will bring will result in fee income being lower than total commission over the life of a typical scheme. Given that contract-based schemes come under the auspices of the FSA, this is likely to lead to advisers being much less willing to market the schemes.”
Which brings us to Nest. Under the new system, employers will be obliged to enrol staff into a company scheme or open a Nest, to which they both must contribute. Significantly, the new schemes will be trust-based, run by not-for-profit trustee body, the Nest Corporation. “The Personal Accounts Delivery Authority is, in a sense, the predecessor to the trustee board,” says Blake. “It is putting a lot of effort into good governance planning, for example design of the default fund, which 90% of members are expected to adopt.
Need to increase take-up
“The government has learned some lessons from the poor take-up of stakeholder schemes. The most important of these is the need for auto-enrolment to increase take-up. If auto-enrolment fails because employers encourage employees to drop out, then the only remaining solution is mandatory participation. Even then, the 8% combined minimum contribution into Nest is not going to generate that big a pension in retirement above the state pension, especially when means testing could leave a number of people with little additional net benefit from their additional pension savings.”
So the introduction of Nest could mean contract-based plans are on the way out. “The new accounts will be trust-based, so auto-enrolment into these will do little to improve the share of contract-based schemes in the future,” says Blake.
He adds the new pension contribution limits for high earners could result in fewer contract-based schemes because staff on high incomes are less likely to be in this type of plan. “The importance of DC plans will continue to increase as [employers] move away from defined benefit provision. But contract-based DC schemes are likely to decline relative to trust-based DC plans.”
Career history: David Blake
As director of the Pensions Institute at City University’s Cass Business School, David Blake has been a leading figure in pension circles for decades. He studied at the London School of Economics (LSE) and received a PhD in UK pension fund investment behaviour from the LSE in 1986.
Blake worked as a research assistant at the LSE before moving to the London Business School. He then became director of the Securities Industry Programme at City University Business School. In 1996, he founded the Pensions Institute, which undertakes research on all pension-related issues.
Blake’s research interests include pension plan design and pension fund investment performance. His published works include A Short Course of Economics (McGraw Hill, 1993), Financial Market Analysis (Wiley, 2000), Pension Economics and Pension Finance (both Wiley, 2006).
Blake is currently researching pensions longevity risk and is one of the inventors of the Cairns-Blake-Dowd stochastic mortality model, which estimates life expectancy. In his downtime, he enjoys drinking fine wines.
Blake’s top tips for contract-based DC pension investment
- Look long term. Remember that a pension scheme can last for more than 70 years: 40 years of contributing and 30 years of providing income.
- Bolster governance. Review the scheme’s governance arrangements. Is it possible to introduce the equivalent of a trustee board to oversee investment performance and other issues?
- Add up contributions. Regularly review both employer and employee contributions to ensure workers are amassing enough to fund their retirement. Consider future investment returns and changes in members’ life expectancy.
- Ditch dud defaults. Make sure the default investment fund offers decent returns without excessive risk.
- Keep a balance. Ensure the default fund shifts to lower-risk asset investments as employees come up to the age at which they want to retire.
- Earn extra income. Make sure workers have access to a range of annuities, including joint-life annuities for those with a partner and impaired-life annuities for people with a health condition. Encourage employees to shop around before buying an annuity.
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