The Financial Services Authority’s Retail Distribution Review and 2012’s reforms are among the factors to consider when formulating a contract-based DC pension scheme, says Ceri Jones
Contract-based defined contribution (DC) pension schemes, such as group personal pensions (GPPs), stakeholder pensions and group self-invested personal pensions (Sipps), are distinct from trust-based pension plans in that the individual policyholder has a direct contract with the provider. This means the employer does not have to shoulder the responsibility for a scheme’s investment performance and any compliance issues involved in offering a trust-based pension. Administration, compliance and scheme documentation are completely taken care of by the provider.
For many years, there has been a move towards contract-based arrangements because of the growing number of employers closing final salary schemes to reduce their risk. Subsequently, employers have turned away from trust-based DC arrangements to avoid the time and costs involved in dealing with the governance these plans require.
The responsibilities associated with trust-based plans are onerous, and employers have to grapple with a raft of legislation, guidance and legal issues relating to operational processes, such as plan rules and registration, levy payments, the appointment of an auditor, annual trustees’ reports and record-keeping.
However, the Financial Services Authority’s (FSA) retail distribution review (RDR) may undermine the popularity of contract-based DC plans. Proposals outlined in the FSA’s consultation paper Delivering the retail distribution review would, from 2012, bring an end to advisers and benefits consultants being remunerated through commission paid by pension providers. Not surprisingly, providers and advisers fear this change would dent their new business figures and some have been talking up the advantages of trust-based schemes that are not covered by the FSA and on which commission can still be paid.
Julian Webb, head of DC at Fidelity, says: “There are good reasons for choosing a contract-based plan – risk, control, cost and these outweigh the short-term advantages of contribution refunds, but trust-based plans are not currently covered by the RDR.”
If the RDR comes to fruition, employers restricting defined benefit (DB) schemes may increasingly favour master trust agreements over implementing contract-based DC pensions. Under a master trust agreement, a new DC section can easily be added to a trust that already exists for a final salary scheme. This has two key advantages. Running a DC arrangement under a DB scheme’s trust allows any surplus generated under the DB scheme to be used to pay the DC contributions. But the FSA will also crack down on these kinds of arrangement in its RDR if they become too popular, says Webb. “This trend to push the master trust is driven by advisers,” he says. “The FSA has promised to take action if it sees a big uptake of these master trust arrangements.”
Another factor threatening to shake up the contract-based DC pension market is auto-enrolment in 2012, which will push up costs for employers as more people take up pension benefits. Employers will have the hassle of establishing whether their existing schemes meet the criteria to exempt them from setting up the national employment savings trust (Nest). The final rules governing auto-enrolment were announced in January. From October 2012, the UK’s largest businesses will join the auto-enrolment regime. Employers will then be staged by size, from largest to smallest, through to 2016.
Jamie Clark, business development manager at Scottish Life, says: “The documentation remains complicated, although some of the finer details about scheme registration and recertification have been diluted after lobbying. The delay is encouraging many employers to wonder if they would be better off setting up Nest because only small contributions are required initially.”
As it stands, an employer will be required to make a contribution of just 1% for up to the first three years, a substantial saving on the contributions most pay for existing schemes.
Martin Palmer, head of corporate pensions marketing at Friends Provident, says: “One area we have got concerns about is how easy it will be for employers to opt out. Self-certification is an issue because the definition of earnings under Nest includes bonuses and overtime, which means employers will have to check they comply with each individual staff member. It may even be cheaper to pay 5% for all employees than to pay the lesser amount, 3%, but include overtime.”
Another concern for employers managing contract-based schemes is how to avoid members’ disappointment with investment performance. The stock market’s dire performance in the past two years has dragged down passive equity funds, which are still widely used for default funds. Many employers are tackling this by taking a more sophisticated approach to their default funds, using multi-asset investments diversified across a range of asset classes. Industry-wide, there is resignation that the default fund should be the prime focus because, despite engagement initiatives, all the cajoling in the world only marginally boosts the numbers who actively engage with their investments. The government’s decision to reduce tax relief for high earners is another challenge for the pensions industry. From April 2011, employees whose gross income is more than £150,000 a year will be taxed on the value of their employer’s contributions, and tax relief on their own contributions will be reduced on a sliding scale, dropping from a 50% rate at £150,000 to the basic rate of 20% at £180,000 a year or more. Inevitably, this means higher earners will look to other methods of saving for retirement, and employers are trying to engage them by making contributions to other vehicles such as individual savings accounts (Isas).
There is also renewed focus on employer-funded retirement benefit (EFRB) schemes. These are approved by HM Revenue and Customs and effectively create a corporation tax deduction for employers with no corresponding income tax charge for the employee.
Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “There is a broad sense that the next generation of pensions will be more flexible, and attention is turning to corporate wrap accounts, giving access to corporate Isas, share accounts and Sipps. Feedback from staff is good. The concept also sits nicely with the noises coming out of the Conservative party regarding the development of flexible pensions that allow the drawing of funds in certain circumstances before retirement.”
Focus on facts
What are contract-based DC pensions?
Contract-based DC pensions are group personal pensions (GPPs) stakeholder pensions and group Sipps set up by employers for staff. Such arrangements are based on a contract between each member and the pension provider. The employer and the employee can both make monthly contributions to build up a pension pot, which the employee will either turn into an annuity on retirement or take it with them if they leave the organisation.
What are the origins of contract-based plans?
GPPs were developed in 1988 as an alternative to trust-based pension schemes. Stakeholder plans were introduced in 2001 as a low-cost way to top up state benefits for people without access to an occupational scheme. Sipps are a relative newcomer and are enjoying a resurgence in popularity because they allow the policyholder to choose investments from across the market place.†
Nuts and bolts
What are the costs involved? Contract-based DC plans are individually priced according to the number and salaries of active members and level of staff turnover, and generally benefit from lower charges than individual arrangements. The only ongoing cost is the annual management charge applied to members’ funds, normally 0.5% to 0.8% depending on the funds selected, and sometimes additional charges are levied when members switch funds. Employer contributions vary greatly, ranging from 2-3% to 14-15%, depending on the industry, with most paid in the professional sectors and by large organisations whose peers offer attractive pensions.
What are the legal implications? Currently, employers with five or more employees must offer a pension, but from 2012 all employers will have to auto-enrol their staff into a scheme. Where a scheme does not exist, they will have to set up the government’s new national employment savings trust (Nest). The Conservatives have promised a root-and-branch re-examination of Nest if they win the election.
What are the tax issues? Employer and employee contributions are both eligible for tax breaks, but in last year’s Budget, the government reduced higher-rate tax relief for people earning more than £150,000.
What is the annual spend on contract-based DC plans?
According to figures from the Association of British Insurers at the end of 2008, contract-based pension premiums amounted to £11.6bn, including GPPs and the old S226 policies, plus £274m of premiums into Sipps.
Which contract-based DC providers have the biggest market share?
No figures are available, but the biggest include Aegon, Aviva, Blackrock, Legal and General, Standard Life and Zurich Life.
Which contract-based DC providers have increased their market share over the past year?
Providers rooted in asset management, such as Fidelity, Blackrock, and Zurich Life, are gaining support from top-end consultants. Legal and General and Standard Life are most active in providing additional investments, such as Isas, in one tax wrapper.