As the regulator toughens its demands on hybrid scheme governance, Ian Smith analyses how schemes including Pennon are managing their administration risk through clear separation of DB and DC funds
The Pensions Regulator is demanding a firm separation of management and investment of DB and DC funds from hybrid schemes, in order to reduce administrative risk to members’ benefits.
Use separate bank accounts for DB and DC;
Provide information to trustees showing DC assets are identifiable “at all times”, and report “regularly” on the systems and processes;
Member communication should make this separation clear, and what would happen in a scheme wind-up;
Provide reports on regular reconciliation of DB and DC assets, and “detailed movement of monies at DC member level”;
Offer open market option and statutory money purchase illustration;
Ensure individual member data accurately reflect benefits split.
Source: Understanding and managing your hybrid scheme
Its statistics showed more than half of hybrid schemes use the same account for these funds, leaving them at risk of costly allocation errors.
But others such as Pennon, together with audit and legal advisers, are already promoting separate accounts for different types of benefits to avoid these "complex and expensive" holding mistakes and improve governance safeguards.
Nigel Ralph, pensions manager at Pennon Group, said it was "good governance" to provide separate accounts for these two types of entitlement.
Pennon is a water and waste management provider which operates two DB schemes with combined assets of £339m and one trust-based DC scheme with assets of £12m.
The scheme management keeps the DB and DC provisions accounted separately, only consolidating them in the financial statement at the end of the year.
Ralph said: "You need to keep DC funds separate because they are by and large allocated to separate members.
"It also means you can separate the costs of running both – the fee we are paying."
Accounting transparency is important, he added, to satisfy the trustees on behalf of the members that there is "no risk of error".
There is still scope for different areas of the scheme to share knowledge when appropriate, Ralph added.
Rules of separation
Teresa Sienkiewicz, a director at KPMG, said the company recommends its clients keep separate bank accounts, following Pennon's example.
“DC requires very tight reconciliation every time money goes in and out of the scheme,” she said. “If you have a separate bank account that is much easier to do.”
Different accounts also allow schemes to separate contributions from one section to another.
Often, schemes have different administrators for their DC and DB sections, making separate bank accounts common sense.
“It is managing your administration risk,” she added. “If you slip up and you don’t allocate money correctly, the unravelling is complex and expensive.”
Victoria Holmes, defined contribution case team leader at the regulator, said best practice would be to have separate bank accounts, but divisions of the same account could be permitted.
She said: "However, if the segregation of a single bank account benefits from the same level of security, governance and reporting, then we would consider this acceptable."
The regulator's statement also said 70% of the 150 schemes it surveyed used the same "individual" investment adviser, leaving members at greater risk from bad investment management.
Understand the benefit and level of protection offered to each type of member;
Review governance framework, and ensure “adequate time” is spent on DC;
Check internal controls on DC elements including cash flows and reconciliation of assets;
Make sure you can correctly identify scheme assets. “Scheme accounts should separately show asset and liabilities allocated to individual members and those which are not.”
Understand insolvency safeguards for different benefits;
Assess advisers separately for DB and DC knowledge;
Check correct information is being given for Pension Protection Fund levy;
Understand how the winding-up process affects different benefits;
Clarify scheme design documents accurately reflect DB and DC elements;
Request auditors to report on testing and separation of different assets.
Source: Understanding and managing your hybrid scheme
The Pennon DB and DC tranches do share a firm of investment advisers, but with separate personnel and lead managers to cater to the different needs of DB and DC.
Background: Legal definitions
The guidance comes at an uncertain time for hybrid scheme managers with the legal definition of their schemes unclear.
The Supreme Court judgement on the Houldsworth v Bridge Trustees case in July agreed with the previous Court of Appeal judgment that various DB add-ons to a pension scheme do not stop it being defined as "money purchase".
The case centred on the Imperial Home Décor Pension Scheme, a DB scheme with added DC layers, some of which had a guaranteed underpin. The scheme began to wind up in 2003 with assets no longer meeting its liabilities.
The decision that the Imperial Home Décor and other similar schemes can continue to be defined as "money purchase", or DC, means they are not subject to funding and covenant legislation.
Ed Hunnisett, senior associate at Norton Rose, said the statement on hybrid DC could be seen as an attempt to make sure scheme managers and trustees understand their current legal set-up before any further changes by the government
He said: "The regulator is trying to get trustees to a point where things are ready now, before things get more complicated."
The advent of auto-enrolment will multiply the amount of employers offering DB and DC entitlements, so the regulator has an interest in setting a guide for mixed entitlements.
In response to the Bridge case, the Department for Work and Pensions (DWP) announced it would seek primary legislation to change this definition.
But Hunnisett warned scheme managers against pre-empting the goverment move with any changes of their own.
He added: "You can't second-guess that the DWP is going to do it. It is not 100% certain."
