Contract or trust?

After the Pensions and Finance Acts, contract-based schemes are closer to trust-based ones but there are still significant differences between the two. James Phillipps assesses which structure is set to dominate

Contract-based arrangements have grown to become the defined contribution plan of choice for the majority of employers in recent years with greater regulatory burdens and perceived expense putting many off taking the trust-based route.

This trend is borne out by Mercer’s latest DC survey, which shows that although there is currently a fairly even split between trust-based and contract-based DC plan types overall, at 53 per cent and 47 per cent respectively, almost two thirds, or 63 per cent, of arrangements set up since 2002 have been contract-based.

For employers setting up a defined contribution pension scheme there has never been an automatic ‘right answer’ to the question of whether to opt for a contract-based or trust-based arrangement and there is no clear evidence as to which generates better performance.

The tax differences between the main types of DC plans have been all but swept away by the Pensions Act 2004 and the Finance Act of the same year leaving the decision to be based on more strategic and indeed subjective issues. Besides cost and regulation, these typically include the company’s aims around the ongoing governance of the scheme, the degree of control it requires over the arrangement and the decision whether to seek best of breed providers for each of the services required for a plan or opt for a bundled approach. The one outstanding difference that lets contract schemes down is the need for higher rate taxpayers to reclaim their relief themselves, something a significant proportion fail to do.

That issue aside, when choosing which avenue to go down much will depend on the employer’s objectives and resources and the nature of its existing workplace offering. But the increasing regulatory focus on the DC arena could see that decision become all the more complicated.

TPR announced in April that “developing and implementing its DC regulation approach” will be one of the four key themes it will focus on over the next three years, (See Box below), and experts warn that contract-based arrangements can no longer be viewed as a ‘no-risk’ option.

“The Pensions Regulator has recently been suggesting a code of best practice for DC schemes, which will mean that employers will no longer be able to put a contract-based arrangement in place and then walk away as they had previously thought,” says Andy Parker, a principal at Mercer. “Although we are not predicting a huge swing back towards trust-based DC plans, this will redress the balance.”

Mercer is a strong advocate of employers with contract-based DC schemes setting up governance committees as best practice. Although TPR has stopped short of making this a regulatory requirement, there is a growing consensus that it is increasingly keen on this becoming seen as the norm.

If it does, then a couple of the major attractions of contract-based schemes over trust-based arrangements- the saving of time and money- are likely to be eroded, according to some experts.

Jarrod Parker, technical and product development manager at Alexander Forbes, points out that the terms on offer from insurance companies for the two plan types are basically the same but it is the cost of maintaining trustees that many companies baulk at.

“There are a number of costs involved, such as paying professional trustees a salary and funding their meetings and audits, which can be avoided by running a group personal pension,” he says.

Although the members of the governance committee would not normally receive extra payments for this additional role, there is still a considerable time-cost.

Jarrod Parker says the committee would generally include the sponsoring employer’s finance and human resources directors as well as several other staff members. Besides the time spent at meetings, the members of the committee, particularly the more senior ones, would generally be expected to undergo a degree of training that would take them away from their normal duties for a number of days, if not weeks, every year.

The cost saving may be slightly less stark, but a governance committee can deliver many of the benefits that trustees do without subjecting employees to the level of personal responsibility that undoubtedly deters some members of staff from taking up the role and leads many companies to favour a GPP or stakeholder arrangement.

“A lot of companies still want to regularly review their scheme and monitor contribution levels, take-up rates, service levels and the investment performance of the default fund,” Jarrod Parker says.

“Governance committees can still carry out these tasks as due diligence but in a way that is not as prescriptive and without the hard-hitting rules and regulations on how they conduct these meetings.”

However, Andy Parker warns that any company setting up a governance committee needs to take legal advice as its level of accountability has yet to be tested. He also stresses the importance of being very clear about who it is and isn’t answerable to and that it is not advising members on what they should and should not be doing.

“There has been fairly limited experience of governance committees being put in place and the liabilities are unclear for the individual. With trustees, if they are acting in the best interests of the members then they have liability coverage for what they are doing. It is a lot clearer for trustees what their roles and responsibilities are and how to cover them,” he says.

Mark Jaffray, senior investment consultant at Hymans Robertson, agrees, saying that the increased regulatory focus on DC schemes and its evolutionary nature mean that contract-based plans can no longer be seen as the “least risk” option for companies wanting to offer a pension but retain no investment, admin or governance risk.

This is particularly the case for schemes without governance committees, he says, noting that the most competitive product when the arrangement was set up may well prove to be a laggard in five or 10 years time.

“Most companies are now realising that should the member’s expected pensions not materialise for whatever reason, either through a trust-based or contract-based arrangement, the most likely recipient of any member dissatisfaction is the company. There is still risk for companies with contract based schemes and the similarities between contract and trust based arrangements are becoming closer,” he says.

Legal & General pension strategy director Adrian Boulding, disagrees, however, and believes that contract-based plans still enable employers to outsource these risks.

“The biggest risk for any DC scheme is the choice of default fund and we know most employees end up in it. If with hindsight it turns out to have not performed well people will look for someone to blame. But all responsibility sits clearly with the insurance company,” he says.

The “overwhelming” majority of L&G’s new DC business is contract-based, Boulding says, and he does not expect this to change.

He says that even if an employer setting up an occupational scheme takes advice from an “A-list” employee benefits consultancy, few, if any, employees are likely to have heard of it whereas they will take comfort from a contract-based scheme being offered through a blue chip product provider.

L&G is also seeing steady business from employers switching their DC arrangement from a trust-based to a contract-based plan.

Chris Clough, a consultant at Lane, Clark & Peacock, says one of the key drivers of this remains the ongoing demise of DB schemes and companies changing their minds on perpetuating the trust. The rebroking of schemes is another major factor as terms on most DC offerings have improved significantly over the years and employers are increasingly keen on more modern and sophisticated pension plans.

“Companies with both DB and DC schemes are also alert to the risk that the trustees spend too much of their time on the DB scheme and not enough monitoring the DC arrangement,” he says.

The onset of the personal accounts regime in 2012 will see the country’s largest occupational DC scheme set up, rather bucking the trend.

If TPR is draconian in its approach to the regulation of DC, particularly contract-based schemes, it is likely to push many employers into the arms of personal accounts. Few would welcome this and TPR clearly has a balancing act to carry out as the lack of clarity around where the regulation of DC is going could mean that personal accounts become the new “least risk” option of choice. n

The Pensions Regulator (TPR) has been increasingly active in its drive to up the standards of trustees.

Since announcing that the closer monitoring of defined contribution schemes is to be a key focus over the next three years, TPR has published several pieces of guidance for trustees and employers and launched a consultation into scheme record-keeping.

TPR’s guidance covers the promotion of the open market option to retiring DC scheme members and best practice in maintaining relations with advisers and providers. For occupational scheme trustees, it has also issued guidance on winding up pension arrangements and last month published guidance to help trustees calculate transfer values for members of defined benefit schemes.

Trustees of DC schemes can expect further reading material hitting their desks over the coming months as TPR has revealed it is to publish guidance focusing on member communications, scheme returns analysis and investment.

These best practice outlines will include case studies and will be available on TPR’s website.

Tony Hobman, chief executive of TPR came under fire from MPs when he came before the House of Commons Committee of Public Accounts in March, with the cross-party body critical of the lack of information held on DC schemes compared to DB arrangements. MPs also voiced concerns that only 15 per cent of trustees have registered for TPR’s free online training course and the vast majority of these have failed to complete all of the modules.

Its record on enforcement was also called into question due to the low number of trustees disqualified. So, although companies’ DC schemes can expect to come under closer scrutiny, they will also be provided with increased levels of support.

Switching from contract to trustAdrian Boulding: “Biggest risk for any DC scheme is the choice of default fund”

expert view

Jarrod Parker, technical and product development manager, Alexander Forbes Financial Services

Switching a client’s workplace pension scheme from a trust- to a contract-based defined contribution arrangement is a fairly straightforward procedure as long as certain pitfalls are avoided.

Chris Clough, a consultant at Lane, Clark & Peacock, says the employer will need to enter into a period of consultation with its staff and develop a communications program to educate employees about the reasons for the change.

“We will help the employer design the communications strategy, which may include a combination of workplace presentations, Q&A’s and letters,” he says.

The use of a simplified enrolment process is increasingly popular with employees being given a one page summary of the scheme, which they sign to authorise contributions being taken from their salaries. This has been found to hugely improve take-up as more lengthy application forms tend to get filed into the ‘to do’ tray indefinitely.

LCP is currently setting up a new group personal pension scheme for a media company with 300 employees, which will replace its old insured occupational scheme.

“The old scheme had an annual management charge of 1 per cent and we have been able to bring that down to closer to 0.3 per cent with the new scheme,” Clough adds.

Companies will often choose to rebroke schemes after suffering poor service levels or following a change of adviser.

However, Jarrod Parker, technical and product development manager at Alexander Forbes Financial Services, warns that advisers must check the fine print of the old scheme to ensure that members are not losing valuable benefits by transferring into a new arrangement.

“You need to be careful where members are transferring from a pre-A Day trust-based scheme because they can lose significant tax-free cash allowances,” he says.

If a large number of employees are likely to object to losing higher tax free cash allowances, the employer may have to look at running parallel schemes or compensating members.