Waking the sleeping dog of DC risk
The last number of years have seen employers very much focused on how to manage and address risks associated with the defined benefit (“DB”) pension schemes they sponsor.
This has resulted in many DB arrangements being closed to future accrual, to contain the risks associated with them.
Typically, defined contribution (“DC”) schemes have replaced those schemes. In general, those DC schemes are ticking along quietly and most finance directors believe pension risks have now been largely contained.
However, DC schemes carry with them an array of different and often latent risks which trustees and employers may not be aware of until years after problems began. Specifically, these risks cover issues such as investment, administration and retirement.
For the purposes of this article, we are going to focus on risks related to DC schemes and retirement.
Main DC scheme risks 1. The advice gap
It is clear from legislation and related Pensions Authority guidance that trustees are expected to “make arrangements for the payment of benefits as” they fall due and provide benefit option statements to members when they reach retirement. However, trustees are subject to very prescriptive obligations in terms of preparing members for retirement. At a regulatory level, the focus seems more on tasking trustees administrative functions associated with paying out benefits.
Trustees are also encouraged to direct members to seek advice on their retirement options.
While trustees can and should provide members with basic information on their retirement options, they cannot stray into pro- viding financial advice to members.
The reality is though that members will require such financial advice, not only at point of retirement but also in the five to 10 years leading up to that date.
There is a debate brewing within the industry about who has the responsibility for filling this advice gap.
At one level, DC schemes are about individuals taking responsibility for their own retirement savings, so it is for them to seek and pay for any associated financial advice they may need. However, that’s not the way many members perceive their DC schemes.
A DC scheme is a benefit provided through the employment relationship.
As a result, many members are assuming that the trustees or employer are taking responsibility for ensuring they are equipped to make the significant financial decisions facing them at retirement.
Arrangements and processes will, therefore, need to be put in place to ensure members are well prepared when the time comes to make those important financial decisions. As DC trustees cannot themselves pay for the advice members will need, they will need to engage with employers on this issue.
What those arrangements should look like will vary from organisation to organisation.
The arrangements may simply involve employers paying for or subsidising financial advice for their employees at the point of retirement. At another level, it could involve organising retirement clinics on site where DC members can meeting with financial advisers periodically as they approach retirement.
While there is a cost to employers in putting such arrangements in place, those costs need to be viewed in the context of potential claim costs which employers may be exposed to if retirement risks are not properly managed.
2. Age discrimination
It is generally acknowledged that the current average level of contributions to DC schemes are not going to be sufficient to provide members with adequate pensions in retirement. As a result, it is likely that there will be a growing theme in the years ahead of employees not being able to afford to retire.
This theme emerges against a changed legislative landscape where mandatory retirement ages must be objectively justified. Where employers now seek to enforce contractual retirement ages and employees find that they cannot afford to retire this is likely to prompt discrimination claims against employers.
We are beginning to see this trend emerge already with a growing number of age discrimination claims relating to retirement ages in recent years. A variety of defences have been used by employers in these cases to objectively justify mandatory retirement ages.
They include health and safety, promoting workforce cohesion and other reasons.
However, the case law makes it clear that the sorts of defences which will work are very case specific, not only to the employer but also to the particular role in question.
For these reasons, employers are best advised not to ignore the retirement age issue until it is too late and should instead put in place appropriate arrangements which will assist in raising awareness of employees’ intended retirement plans. Depending on the organisation and the type of roles involved, some employers might also consider extending retirement ages to align them with increases in the State pension age as a means to mitigate risks associated with this issue. However, doing so is likely to throw up a number of legal and other issues which will need to be carefully managed.
3. Investment switches and out of market risk
As fund members get close to retirement, the whole area of investment switches then becomes an issue that also needs to be managed very carefully.
If members investment switches are made late or not made at all then any loss in value associated with such errors is much more difficult for members to recover from.
They will naturally look to the trustees to make good such losses. Also, once the pension fund members have decided how they wish their DC pot to be applied at retirement there is likely to be a gap between disinvestment from the scheme and reinvestment into an ARF product, for instance.
Again, any significant movement in asset values while that transition from one investment to another is taking place may cause members to suffer losses they would not have suffered if that out of market risk had been minimised.
It is vitally important, therefore, for all trustees to ensure that they have robust procedures in place with their administrators and for investment managers to minimise the risk of any such errors or delays.
While most people are aware that there are risks associated with any pension plan, many will need some expert help in understanding the risks and their own responsibilities with defined contribution (DC) pension schemes — a sleeping dog that can no longer be left asleep.