Fundamental question: Contract DC targets uplift

As defined contribution schemes adopt a similar approach through sophisticated managed default funds, it has been suggested that the advantages of trust-based DC schemes over contract-based is being eroded. But is this really the case?

Traditionally, contract-based DC schemes such as group personal pensions have been seen as the poor relation to more sophisticated DC schemes managed by trustees.

The difference between the two is that a trustee board can hire investment managers and administrators and directly manage communications and at-retirement policies as they are legally responsible for their members’ pension.

The alternative is that each individual member has a direct contract with a pension provider which manages fund ranges, communications and administration, with the employer either keeping a watchful eye over the arrangement or taking a back seat.

Sponsors of contract-based plans who wish to keep close to the scheme have increasingly been setting up governance committees. These have no legal responsibility, but are meant to carry out a similar oversight to that of a trustee board.

One of the key duties of DC trustees is to design, monitor and review the fund options presented to members. Some have designed their own default fund, fusing equities, bonds and diversified growth funds together. Others have put together small ranges in a similar fashion, offering different levels of risk.

But with the onset of auto-enrolment, the trend is moving towards either managed target date funds or automated lifestyle funds with a diversified investment strategy under the bonnet.

For target date funds – where a third-party helps to select or manage underlying managers, as well as organise the asset allocation over time – the approach of the trustees alters significantly.

The focus of attention will shift towards assessing the performance of the target date managers and reviewing the appropriateness of the fund options as a whole for the workforce.

One provider may even also be called on to deal with the admin and communications, at which point the trust-based DC plan starts to look very similar to a contract. Like a governance committee, the trustees monitor the overall arrangement but do not get involved in the working of each of its parts.

But there remain subtle yet important differences between the two approaches. Under a contract scheme there is a direct legal relationship between the pension provider and the member.

For a trust-based plan the legal relationship is with the trust and the member. Were some part of a contract plan to go badly wrong, the sponsor will find it difficult to unpick the arrangement without a great deal of disruption. Potentially, members could find themselves switched out of one fund or a set of funds and poured into another set that seem quite different.

In a worst-case scenario, members may find the pension built up to date frozen, and have to start afresh with a new one – which could prove chaotic and deeply unpopular. Not surprisingly, sponsors rarely take this approach even when they are unhappy with arrangement.

Under a trust, however, the trustees remain more in control with greater ability to alter administrative arrangements and rein in communications if they have been outsourced. They could also change target date managers, although this may still be disruptive.

But the benefit for contract-based plans should not be underestimated. They have often been derided chiefly because the fund options are poorly thought through and members find it difficult to understand them.

If a GPP were to use a target date fund approach those issues would be resolved, and from the members’ point of view the scheme will likely be much more appealing. What target date funds achieve is a major upgrade to contract-based plans through the addition of professional fund manager and asset allocation oversight.

As a result, employers may be more amenable to a contract-based plan. But its overall design and crucial elements such as administration and communications will be much more difficult, if not impossible, to control. The National Employment Savings Trust, after all, is a trust-based plan, as are The People’s Pension and Now.

The reason is that only through a trust can control be maintained, allowing for significant changes to be made over time without inconveniencing and confusing the members.

Without doubt, target date brings GPPs a significant step closer to trust-based DC plans, but a trust will always retain its governance edge.

Bob Campion is a freelance journalist

Raising the bar for DC governance

There is a widespread belief in the pensions world that achieving good fiduciary oversight of the investment strategy is more difficult with contract-based schemes than with their trust-based counterparts. We think that is a fallacy.

We would argue that the arrival of modern flexible target date funds means that equally robust investment governance can be delivered in both types of arrangement. We’ve certainly found that to be the case in the contract-based retirement scheme we run for our own staff, where we have been using them for more than three years.

The beauty of TDFs from a governance point of view is their simplicity. There is no need for any complicated fiduciary oversight to be tacked on: it comes built in as standard.

Like all good governance arrangements, with TDFs it relies on ensuring the management process is separated completely from the monitoring function. Thus, where a contract-based arrangement uses TDFs, the employer still sets the objectives for the scheme, but a professional fund manager is made responsible for ensuring that the investment approach meets those requirements.

The employer – perhaps using the services of other professional advisers – can then monitor whether or not those objectives are indeed being met by the investment strategy. The crucial factor is that the employer has no active role in the management of the assets. This means they can be much more objective in assessing whether the investment default approach is meeting their members’ goals right across the age range.

Given this separation of roles, such an arrangement can only serve to improve the image of the scheme from the point of view of both the employee and the regulator. After all, good governance must not only be done, but be seen to be done.

But while this separation of duties is vital to good governance, the fiduciary responsibilities of those providing even a contract-based pension scheme go much wider than that. After all, in a defined benefit arrangement where the employer is on the hook for the delivery of a pension income, a great deal of energy is expended in trying to ensure the level of return being sought from the assets is commensurate with the risks being run.

We see no reason why a similar balance should not be sought in a contract-based DC arrangement, where the member is ultimately on the hook for their own pension income.

Luckily, by establishing an asset allocation ‘glide path’ that adjusts to meet the risk-and-return needs of members as they age, TDFs provide the right level of trade-off at any point in a member’s life.

In doing so, TDFs are agnostic as to whether the scheme is a contract or trust-based one.

Tim Banks, AllianceBernstein