From all the publicity surrounding underfunded pension schemes you could be forgiven for thinking that the Pensions Regulator is only concerned with defined benefit schemes (also known as ‘final salary’ schemes since the pension benefits are linked to earnings). And indeed the regulator has been working to improve funding, and has helped trustees and employers to reach a fair deal for scheme members in a number of high-profile cases where defined benefit schemes have been in difficulty.
However, the responsibilities and objectives of the Pensions Regulator relate to all worked-based pensions, and the regulator has also been addressing issues relating to defined contribution (or ‘money purchase’) schemes since its inception in April 2005. In fact, although defined benefit schemes account for over three-quarters of member records, the great majority of schemes are defined contribution and most new schemes are being set up on a defined contribution basis.
What is a defined contribution scheme?
In a defined contribution scheme, a member’s pension is based on the contributions paid plus the investment growth on those contributions. The fund built up in this way is converted into an income at retirement.
There are two main types of defined contribution scheme for employees:
- occupational schemes that are established under a trust and which comprise either a pooled fund covering all members or a range of funds from which members can choose, usually with a default option (it is possible for the scheme to be a DC section within a trust that also has a DB section); and
- contract schemes which may be stakeholder pensions, group personal pensions, or individual personal pension schemes to which the employer makes a contribution or provides access. The contract is between the members and the provider (insurance company) so that each pension is specific to the member concerned.
Schemes established by the employee where the employer has no role are not a matter for the regulator.
The employer’s involvement
The employer’s involvement in a defined contribution scheme can include making employer contributions, and deducting contributions from the employee’s pay which are then passed to the insurance company or pensions provider. Employers also have a responsibility for passing certain information to the scheme administrator or scheme provider when requested. And they are likely to advertise the scheme to employees and often encourage them to join, which means that they have some obligation to ensure that the scheme is well governed.
The legal and regulatory framework for contract-based schemes is different from that for trust-based schemes. With trust-based schemes there is a group of trustees who look after members’ interests. With contract based-schemes the employees have a policy with an insurance company, in their own name, that they can carry on paying into after they leave the employer. If you are currently reviewing pension arrangements for your employees, you may want to get advice on which type of scheme might be most suited to your requirements.
You may have read about the government’s recent white paper on pensions proposing a National Pension Savings Scheme (NPSS) and wonder what this will mean for your scheme. NPSS is designed for those employers who do not already have a pension scheme in place. Introduction of NPSS is planned to take place in 2012, so it is important that existing schemes are maintained to a high standard.
The member’s point of view
The retirement income received by a member of a defined contribution scheme will be determined by a variety of factors:
- The level of contributions. The amount of money paid in by you and your employees is, of course, a key factor in determining the likely adequacy of the retirement benefits.
- The type of fund invested in. A range is generally offered to cater for the different situations and preferences of members, for example with different levels of risk, or investment in different sectors of industry or geographical areas.
- Investment growth. This will be influenced by the type of fund selected by the member; for example, lower risk funds tend to give a lower return over time, but give more capital security.
- Annuity rates at retirement. An annuity is a guaranteed income for life, and rates are linked to long-term interest rates.
Although defined benefit schemes are generally regarded as the most beneficial from the member’s point of view, there are some advantages to defined contribution schemes. For example, in comparison with defined benefit schemes they offer members more control over how their money is invested and how they draw their retirement benefits. Furthermore, there is no risk to the benefits in the event of employer insolvency. Indeed, a well-designed defined contribution scheme can be as beneficial to employees as a defined benefit scheme, providing an adequate level of contributions is maintained.
Keeping your scheme running smoothly
There are several key areas to keep under review on a defined contribution scheme to ensure that both you and your employees are getting good value from your investment:
- Administration. Is everything running smoothly? Do new employees receive joining information, and are contributions paid on time?
- Costs. High costs can erode the returns members will get and so will reduce their retirement incomes. Are the costs borne by members reasonable given the nature and level of the services offered?
- Retirement options. Do members receive good quality information on their options at retirement or do many members make bad choices? For example, do they realise that exercising the ‘open market’ option (moving the pension pot at retirement to the company who will offer the highest income) could materially increase their income? Have they chosen to take an income that stops when they die without thinking about what happens to their spouse or partner?
- Investment options. Is the investment performance of the funds reasonable, and is the fund choice reasonable given the current market? In particular, if your scheme has a default fund (the fund to which contributions are allocated unless members make a positive decision to invest elsewhere) this should be monitored as most members typically invest in the default fund, and they are often those least able to monitor performance themselves.
- Member understanding. Many members are not particularly well informed about pensions, so it is helpful if they are given appropriate assistance. Clear, simple and helpful information is the key.
You are free to promote your scheme to employees without the need for any type of authorisation. Most employers will not, however, be in a position to give personalised advice and should refer employees to an authorised adviser where this is necessary.
Education and guidance
The Pensions Regulator’s primary approach to regulating defined contribution schemes is to provide education and guidance, and we have published several codes of practice which provide clear and straightforward guidelines on ensuring that the schemes are well run. Furthermore, the regulator has devised a free e-learning resource, the Trustee toolkit (www.trusteetoolkit.com), for trustees and everyone involved with pensions. It includes modules on pensions law, trust law and investment that are of direct relevance to defined contribution schemes. Access to the trustee toolkit is open to everyone and employers, administrators and advisers are all likely to benefit from it.
There are certain minimum standards, requirements and responsibilities imposed upon the operation of defined contribution schemes.
The Pensions Act 2004 stipulates that employers must pay all contributions at the correct amount and at the correct time. Where employers are responsible for passing information to the scheme provider, such as names of members, earnings, contribution levels and details of leavers and joiners, then employers are required to provide the information promptly and in a correct form.
Employers with over five employees who do not have an adequate existing pension scheme are, in most cases, obliged to provide access to a stakeholder pension scheme for their employees. A stakeholder pension is a low-cost flexible type of personal pension. Providing access to a scheme like this is very straightforward, and a free information pack for employers that covers all the necessary steps is available from the Pensions Regulator. We also maintain the stakeholder pension register, and we are responsible for ensuring that registered schemes comply with the stakeholder requirements such as the cap on management charges.
Working in partnership
Working in partnership with the pensions community, the regulator intends to build a firm foundation for confidence in all work-based pensions, and later this year we will be issuing a detailed consultation document on the regulation of defined contribution schemes and inviting feedback from all those involved in pension provision.
To find out more about the regulator, read our codes of practice and other guidance, request a stakeholder pack or register for email updates, please visit our website at www.thepensionsregulator.gov.uk.
Other useful contacts
The Pensions Advisory Service provides information and guidance on all types of pension schemes. They will help people with individual pension problems and disputes and can reached on 0845 601 2923. The Financial Services Authority regulates the sale and marketing of personal and stakeholder pensions to individuals. It also oversees the financial viability of organisations that manage pension investments, and can take action to make sure that the individuals who run financial organisations are fit and proper for the task. See www.fsa.gov.uk for further information.