The Department for Work and Pensions’ (DWP) guidance on providing default options will prompt tighter governance controls for some schemes in the run up to auto-enrolment
Fund managers and consultants have claimed the latest guidance note – released this week – will serve as a checklist for more robust schemes, but should cause concern for others with auto-enrolment just months away.
Schemes are urged to conduct a wholesale review of their default option every three years, taking into account the risk profile of the membership and ensuring it has a competitive charging structure.
From next year, employers will begin to have to automatically enrol their workers into a qualifying pension scheme, which under section 17 (2) of the 2008 pensions act must include a default option.
The guidance – which was developed in conjunction with the Financial Services Authority and in consultation with the Pensions Regulator – seeks to set out the standards for governing, designing, reviewing and communicating default funds.
The DWP said it would be reviewing adherence to the guidance through tools such as its charges survey, as well as receiving reports from the regulator.
The DWP described its guidance as “principles-based and… a statement of good practice intended to support existing legislation”, but clarified it was not regulation.
However, it added that if its reviews found the guidance was being wilfully ignored it would consider using statutory instruments to ensure the guidance was adhered to.
The guidance lays out a governance structure for maintaining a default fund:
assess the membership to develop a suitable default option;
design the default option;
monitor the performance of the funds which support the default option;
communicate information about the default fund to members;
regularly review – and if required, change – the default option.
Each stage should be assigned the responsibility of one of the stakeholders in the scheme (the trustees, management board, employers, fund managers and consultants). The details of which should be made available to members on request.
Design stage
Schemes should start by writing out a high-level objective for the default fund, which includes an overview of its investment strategy and how it aims to achieve desired member outcomes.
“Understanding the difference between the risk that members need to take and the risk they want to take is incredibly challenging,” said Mark Fawcett, chief investment officer at Nest. “But it’s the most important part of the whole default fund design.”
The default option’s design should be suitable for the types of members likely to invest in the fund, taking into account their contribution rate, risk appetite, retirement profile and the types on investments in which they currently invest.
“Conduct some data mining of your scheme members,” advised Lee Hollingworth, head of DC consulting at Hymans Robertson.
“You would be surprised by the number of schemes who don’t understand what decisions their members are making.
“There is no reason why they can’t commission some research with their administrator, as long as the trustees can identify exactly the types of data they are looking for.”
The guidance also calls on schemes to ensure their default options are competitively priced, and any charges to third parties are clearly disclosed, should members request them.
Review stage
The guidance also calls on schemes to review their default option at least every three years to make sure it is still suitable for the membership in terms of risk, and that it also carries competitive charges.
“Small schemes using old-fashioned insurers with their old fashioned charging structures need to revaluate whether their fund charges are competitive,” said Daniel Smith, head of defined contribution (DC) business development at Fidelity.
He added this could be reviewed through a re-tendering process or by benchmarking against other fund providers.
The review should also asses the performance of the fund and whether it is capable of providing members with their required income in retirement. The DWP said the performance should be informally monitored at various intervals throughout the year.
The guidance sets out a number of scenarios where ad hoc reviews of the default option may also be necessary. These were:
a change in the charging structure;
consistent overperformance or underperformance of the funds underlying the strategy;
a significant change in the scheme’s member demographic;
significant changes to the financial markets or economy; and
a significant and relevant change to legislation.
The DWP also asked that any changes to the default option following a review – as well as the reasons for such changes – should be documented and made available to members.
Likewise, if there were no changes made, the reasons for such decisions should also be made available to members.
Communication stage
The regulations governing auto-enrolment state members should be provided with clear information on the default option, which the guidance suggests should include details of: the objective of the fund, including information about the risk profile; the charging structure; and details of where members can seek further information.
The guidance also requires schemes to provide information of how the fund’s objective will be achieved, its investment strategy and who has responsibility for that, should members request it.
Schemes are also called on to make available information of reviews of the default option, as well as information on managing risk as the member nears retirement.
