As more defined contribution schemes reach a tipping point where deferred members begin to overtake their active counterparts, Ian Smith explores the cost, and how it can be shared
This problem is set to be exacerbated by auto-enrolment, expected to create a great deal of “churn”, where workplace schemes are left with a series of small, deferred, retirement saving pots by short-term employees.
Schemes can reduce these costs by sharing administrative and investment charges with their deferred members, increasing the security of benefits for the rest of their membership.
Small legacy savings from ex-employees are costly to administer, and no longer provide the retention advantage they did when the member was still working at the company.
On the other hand, they contribute towards the negotiation power of schemes looking to reduce investment charges, by pushing up the aggregate plan assets. But this is seen as a limited advantage by consultants.
Unbundled, trust-based schemes – where the third-party administrator is separate from the investment manager – are beginning to share ongoing costs of deferred members with those members themselves.
Gurmukh Hayre, head of DC pensions at KPMG, said: "Some schemes are now working out the cost over the year and working out a new administration cost against the member account."
This is being calculated by schemes as a flat charge, per member, or as a percentage charge based on the scheme's annual cost, levied on the individual member's fund.
Stephen Richards, an associate at Allen & Overy, said there are two key hurdles for trust-based schemes wanting to encourage members to transfer.
Transferring out: this requires member consent.
Transferring in: financial regulations require a ‘know your client’ exercise on behalf of the client.
Contract-based DC schemes such as a group personal pension do not present this problem as deferred members can be broken off as personal pensions, albeit facing higher fees as individuals, when they leave an employer.
The cost of administration and investment is also shared, as it is done on one platform, meaning a more-efficient cost structure, but lacking the investment governance of the trustee model.
Regulatory arbitrage
A key concern of the Department for Work and Pensions (DWP) is so-called “regulatory arbitrage”, where employers take advantage of short-service refunds to rid themselves of small legacy savings once an employee has left the company.
Short-service refunds are paid to members who leave the scheme within two years and do not qualify for a short-service benefit. The government is concerned this could be abused by employers.
Video: Preparing for short-service refund changes.
In its response to the discussion paper on regulatory differences between occupational and workplace personal pensions, the DWP reported back some of the solutions put forward in the consultation. These included moving all small pots into Nest and introducing an automated transfer system.
But the government has made it clear DC schemes and their sponsors should not merely expect a continuation of the status quo.
The DWP response said: “Since our priority is to help more people save more for their retirement, we would encourage employers not to make their decisions about scheme type on the assumption that short service rules will continue to exist in their current form.”
Richard Wilson, senior policy adviser at the National Association of Pension Funds (NAPF), welcomed the government’s acknowledgement of the NAPF’s “strong” submission against abolishing short-service refunds.
He said: “It would be bad for everyone involved, and I’m glad the response recognises that.”
The NAPF is proposing Nest become the natural repository for the small pots of deferred DC scheme members, along with any other receiving scheme which would want to participate.
Firms such as Legal & General have explored the legality of their own mastertrust becoming such a scheme.
But substantial changes to the law are still required to reduce the risk to the member, the trustee and the cost of the process to the scheme.
“It’s very difficult to do at present,” Wilson added. “We’ve had some people look at it. It needs to be automatic, so it isn’t burdensome.”
