Default DC structures require closer scrutiny

This is the orthodox position, and has a ring of truth to it. DC version 1.0, as we might refer to it, has been under the microscope for some years and has been found wanting.

There are anecdotes aplenty of schemes cobbled together where the guiding principle was neither choice nor security for the members, but to save money.

As a result, communication is limited, administration is at times questionable and the investments have either too many or too few poorly selected – and poorly performing – funds that receive insufficient attention from the majority of trustees, where they exist, or employers of contract schemes.

It has been a lack of proper governance, or any governance at all in some cases, that has brought DC into disrepute. But it is a fact of life that DC is the pension structure for the 21st century. So, isn’t it time new-style DC investment options replaced ineffective, old-school default funds?

Henry Tapper, a director at First Actuarial, doesn’t agree all the old formats are necessarily unfit for purpose.

“Just because the standard passive lifestyle structure is boring, it doesn’t mean it is wrong,” he says. “It doesn’t give active managers any work and it doesn’t give journalists anything to write about, but that doesn’t make it bad either.”

Philip Mendelsohn, a managing consultant at Atkins and a trustee of its pension fund, disagrees with Tapper. He says members with a potential 40 to 45-year membership will go through a series of lifetime events, creating a mix of factors, which must affect the individual’s investment appetite.

He accepts there is a need for a default for those who do not engage, but that should reflect the typical lifecycle of a scheme’s membership.

So, through engaging with employees and holding up a possible scenario they may measure themselves against, Mendelsohn believes members will be encouraged to make active decisions. It sounds counterintuitive, but he is not speaking of simple mailshots or even colour brochures.

Just because it is cheap does not make it good, says Mendelsohn. Sponsors already spend a lot of money, so in spending a little more to communicate the value of the pension offering and accepting slightly higher investment charges, they deliver better value and members will better appreciate what they are getting – and not getting.

“This is a very dynamic marketplace and providers will respond to what we need. We have to turn down what is too expensive and encourage suppliers to develop what is good value,” he adds.

The bad news is that a study from Mercer last autumn showed that although nearly 80% of UK employers surveyed measure the success of their DC scheme by whether they are valued by employees, only 16% felt they had achieved this objective.

Unsurprisingly, reducing the volatility of costs as well as overall costs were the key criteria when setting up DC plans. However, the dynamic market Mendelsohn speaks of is already here.

The annual research by PensionDCisions into default DC funds shows providers are increasingly introducing greater flexibility in their product models and more sophisticated derisking mechanisms.

In fact, the survey in 2010 demonstrated that placing greater faith in the products constructed by fund managers would have delivered greater returns than up to 90% of members of DC schemes.

Of course, you can remove a default option and force people to make decisions, but they can do this for the wrong reasons. Many will argue if you feel you can’t make an informed choice, you are probably better off not making a choice at all, and defaulting.

However, the discussion is broader than simply the performance of default funds, says Yvonne Pearce, global pensions director at Accenture. The market – including scheme professionals and advisers –  must address what she calls the “disconnect between structure and engagement”.

“If we structure a good DC plan so the member does not have to think about what he contributes or where he invests it, you immediately disengage from making any thoughtful decisions or long-term planning,” she says. “Default funds will always fall over because one size cannot fit all.”

The publication of principles and best practice guidelines for DC schemes from the Investment Governance Group in November 2010 is a clear signal to schemes and providers that the regulator expects to see increased levels of governance in the area of DC investments.

There is little doubt the regulator will continue to ratchet up its expectations – it has been on the cards for at least a couple of years. But the days of ignoring what is going on in the DC scheme, or setting up a cheap DC scheme and leaving it to muddle on, are gone.