Fundamental question: governance committees
Employers are finding defined contribution governance committees increasingly practical as auto-enrolment approaches, says Bob Campion.
If companies with defined contribution pension schemes are unfamiliar with what governing such a scheme entails, they soon will find themselves on a steep learning curve.
Sponsors are going to have to review everything as a result of auto-enrolment over the coming years and governance will soon be a major challenge for employers across the country. But what does governance mean and who is supposed to do it?
Who’s the guv’nor?
Allocating responsibility is straightforward for trust-based schemes where the trustees are legally accountable. But for the myriad contract-based DC plans the impression has been given for many years that responsibility falls between various company departments and the pension providers, with no clearly identifiable group in sole charge.
That is why the pensions industry has been encouraging sponsors to establish committees which can take responsibility and be seen to be doing so.
Unlike a trust board, a governance committee has no official powers and must make up its own rules
Such committees could consist of heads of human resources, payroll, pensions and/or finance alongside employee, union and scheme member representatives in a mix similar to that of a traditional board of trustees.
But unlike a trust board, which is governed by statute, a governance committee has no official powers and must make up its own rules.
Starting with a blank sheet of paper can be quite daunting and time-consuming for what is typically a voluntary committee. So are employers actually doing it?
“Yes they are,” answers Dan Smith, business development director for DC and workplace business at Fidelity. “The big employers know there are risks of not doing so.”
In addition to any moral obligation the sponsor may feel towards its workplace is the concern that if DC schemes are not well governed and do not offer attractive retirement options to ageing employees, then they will not retire.
And with auto-enrolment on the horizon, having a multi-disciplinary team familiar with the issues and responsible for managing the process could be extremely beneficial.
The main tasks
There is no doubt the task of a DC governance committee is much simpler than that of a defined benefit trust. There is no requirement to go through complex actuarial valuations, filing regulatory funding returns or pay levies to the Pension Protection Fund.
But tacking the DC section onto the end of a long board meeting will not do any longer either. The main tasks for a DC governance committee is in member communication and investment strategy.
Communication is important, because the committee has to find the right way of explaining to members what choices they have and the impact of those decisions, without straying into language that may be construed as advice. But committees should not shy away from direct language.
Saving into a pension gives you ‘free money’ because the employer tops up or matches your contribution, depending on circumstances. Some companies who have focused on this message have seen take-up rates grow substantially.
For existing or new members the message focuses on key decisions – contributing more to a DC scheme at a younger age is the surest way of boosting a final pot, and members need to see generic numbers to understand how this works.
The impact of fees and costs over time cannot be ignored either, not with all the bad press that money purchase pensions received over the summer. And when it comes to fund choices, explaining what risk means is important.
All too often members are faced with lower or higher risk options without understanding what risk means in this context. Generic pension plan packs often fall short in this area and it is up to the committee to ensure the message hits home.
Fund ranges
Invariably it is the fund range that will attract most of the attention of a governance committee, and there is much to do. Setting up and reviewing the default fund or funds is the main task, followed by deciding what additional funds to offer.
Diversified growth funds are fast becoming the most popular default option, following the lead of the National Employment Savings Trust and auto-enrolment schemes, but committees must bear in mind additional costs.
Off-the-shelf DGFs can cost 0.75 per cent a year or more, compared with 0.2 per cent or less for a passive equity fund, although cheaper passive DGFs are coming onto the market.
On the top of that the committee must decide whether to offer a lifestyling or target date structure to reduce investment risk.
Lifestyling has been popular for many years, but is now coming in for criticism due to its automated switching process. “Lifestyling is a formula that can easily do the dumb thing at the dumb time,” says Tim Banks, head of DC sales and client relations at AllianceBernstein.
Received wisdom is a moving feast as auto-enrolment picks up pace and committees have much to consider, whether their staging date is fast approaching or further down the line.
Bob Campion is a freelance journalist
Don’t dodge the governance question
The defined contribution pensions industry has been debating governance best practice for years. Since 2012, these discussions have crystallised into principles issued by both the Pensions Regulator and the Department for Work and Pensions.
Yet, despite this extensive guidance and with auto-enrolment just around the corner, we still often see DC schemes whose governance leaves considerable room for improvement.
Putting professionals in charge of asset allocation and management should not only ensure performance improves but, crucially, means they are accountable if it doesn’t
In our view, there are two basic requirements for robust governance.
First, that pension scheme members have confidence someone is looking after their best interests.
Second, someone is actively managing the investment strategy on members’ behalf, who can make changes when they need to be made and is on the hook if things go wrong.
In other words, robust governance needs independence of oversight and accountability for performance.
The problem is these principles are muddled or non-existent for many DC schemes. For instance, those who set the overall objectives also often choose and manage the investment funds and then monitor their performance.
This is not a robust governance structure, while also placing unnecessary burdens on trustees and employers. Far better to keep objective-setting and performance-monitoring functions separate from management of investments.
Putting professionals in charge of asset allocation and management should not only ensure performance improves but, crucially, means they are accountable if it doesn’t.
The fundamental question is about design. Does the way the scheme is structured, and the default offering in particular, build in good practice when it comes to governance?
The answer for many schemes that have adopted a lifestyle approach is a clear “no”. Certainly, they permit investment risk to be reduced in the crucial period before retirement, when members are least able to absorb market losses.
But lifestyle is an individual arrangement, so any fund and asset allocation changes can only be made by buying and selling separate funds within the member’s own account.
Not only is this cumbersome, it is confusing for the member and it makes it hard to implement timely adjustments.
Flexible target date funds offer something much better. Because they rely on members of similar ages joining a single fund, they allow far greater flexibility.
Changes of investment or asset allocation can be made without the upheavals, cost and scope for error involved in using multiple funds.
Flexible target date funds are tailor-made to meet the increasingly exacting demands of governance in a world of auto-enrolment and default funds.
Tim Banks is head of DC sales and client relations at AllianceBernstein