Contract-based DC is still playing governance catch-up

This has been initiated by the introduction of auto-enrolment, and the resulting drive to raise scheme governance standards and improve member outcomes across all DC schemes.

However, there are still important differences between contract and trust-based DC schemes, most notably in relation to governance and investment.

Governance

Contract-based schemes are often viewed as the cheap and cheerful alternative to a trust-based scheme.

Employers like them because they do not impose a trustee body and result in reduced adviser costs.

The Pensions Regulator’s guidance ‘Monitoring your pension scheme’ has tried to redress the imbalance.

Unless and until employers are required by law to set up committees and those committees owe legal duties to scheme members in the way trustees do, there will continue to be a governance gap between contract and trust-based schemes. 

It sets out best practice for monitoring contract-based schemes and recommends an employer sets up a management committee.

The guidance includes recommended terms of reference for the committee, which cover costs and charges, member communications, service standards and member engagement – the very same issues as those on a DC trustee’s agenda.

However, trustees have fiduciary duties to scheme members that require them to consider these issues, in addition to regulatory pressure to do so under the DC code of practice and regulatory guidance.

Meanwhile, employers are not under an equivalent legal duty and the regulator acknowledges that employer governance arrangements are purely voluntary.   

And the gap was not completely filled by the introduction of independent governance committees in April this year.

IGCs are required to act in the interests of scheme members, both collectively and individually, but only in the context of value for money and charges issues.

Any recourse a member may have to an IGC is, therefore, limited.

The Financial Conduct Authority consumer protections do not fill the governance gap either, since they do not provide an equivalent level of depth to that offered by a trustee board dedicated to the interests of the members of a single scheme.

Unless and until employers are required by law to set up committees and those committees owe legal duties to scheme members in the way trustees do, there will continue to be a governance gap between contract and trust-based schemes.

Investments

The issue of scheme investments provides a key example of this. 

It is clear that under a DC scheme the member bears the investment risk, but trust law distinguishes between risk and responsibility. 

The responsibility for investment decisions rests with the trustees, who owe duties to members in relation to the choice of investments offered by the scheme.

Trustees are also expected to proactively monitor the scheme’s investment funds.

An employer must ensure that the contract-based scheme it chooses for auto-enrolment offers a default fund. Otherwise employers rely on the provider to offer a reasonable range of funds.

Even if an employer does want to play a more proactive role, it is restricted in the ongoing advice that it can provide to employees under the Financial Services and Markets Act 2000.

There is no obligation, nor much in the way of incentive for providers to review regularly the funds offered under a contract-based scheme. 

IGCs are required to review default investment strategies but no other investment fund strategies so, again, compared with trustees their role is very limited. 

Although the gap has closed over recent years, there is still a long way to go before a member of a contract-based scheme has the same protections offered to members of trust-based schemes. 

It remains to be seen whether these differences mean trust-based schemes deliver better outcomes for members than their contract-based counterparts.

Nicola Rondel is a counsel at Hogan Lovells