DC - but not as we know it

Trusteeship generally is becoming more and more complex every year. Pension regulators are placing
increasing demands on the trustees of occupational pension schemes. Trustees are now required to consider their investment objectives more closely and, in particular, their investment strategy. For example, the range of provisions contained in the Occupational Pension Schemes (Investment) Regulations, 2006 requires trustees to put in place a statement of investment policy principles (SIPP) and to keep it up to date. The regulations are quite specific about what should be contained in the SIPP. Trustees must now ensure that it includes the following:

q the investment objectives of the trustees;

q the investment risk measurement methods;

q the risk management processes to be used; and

q the strategic asset allocation implemented with respect to the nature and duration of pension liabilities.

While most of the above requirements would previously have been considered areas confined to defined benefit (DB) scheme management, interestingly, the regulations do not distinguish between DB and defined contribution (DC) schemes. As a result, trustees of DC schemes must interpret these requirements in the context of DC and decide what is expected of them.

In the past, many DC schemes would have had objectives such as "to maximise return within an acceptable amount of risk". However, these plain vanilla objectives are meaningless unless the parameters described above have been considered and established. More specifically, the trustees must decide exactly what they are trying to achieve via their investment options made available to members, how they will measure them, and who will manage the products and the risk. More specifically, what is an "acceptable amount of risk?" Or more importantly, "what risk are we talking about"? Is it the risk that investment managers underperform their peer group or benchmark? Or is it the risk that members have insufficient funds to retire? Trustees must decide on the answers to these questions and then reflect them in their objectives.

For example, is the objective to "maximise return" irrespective of contribution levels? Or is it to "maximise the pension that can be purchased at retirement"? If it is the latter, scheme design may need to be revisited. The process of setting and documenting a clear objective has led to some trustees/sponsoring employers thinking about ways to more closely align their corporate culture and/or ethos with their benefits package/pension plan. Some have concluded that simply endeavouring to maximise the return of their employees' DC pension pots is not enough. After thinking about their objectives, some sponsors have chosen to offer hybrid schemes that will assist in achieving a somewhat more member-oriented objective related to the pension that can be purchased at retirement. In these cases we have been involved in the design of ‘cash balance' and ‘retirement balance' schemes where the objective is somewhere between that of a DB scheme and a DC scheme.

In a cash balance plan, the member's benefit is typically an entitlement to a capital sum at retirement which is converted into an annuity in a similar fashion to DC plans, typically at market annuity rates.

However, the differentiating characteristic is that, unlike DC plans, the amount in the member's account is not directly related to the returns achieved on the underlying assets, but it may be guaranteed or smoothed or subject to some form of underwriting by the company. There are significant variations in the types of guarantees offered, and the terms for annuity conversion, which lead to these cash balance plans looking progressively more like defined benefit plans or like defined contribution plans.

In retirement balance plans the phrase ‘retirement capital' is also sometimes used to describe plans similar to cash balance plans. However, it is important to draw the distinction between the two plan types to avoid any potential pitfalls in design, implementation and communication.

The primary difference between cash balance and retirement balance would be that in cash balance plans the member gets the face value of his pot (or accrued benefit) if he chooses to transfer out or retire early. In retirement balance plans the member gets a discounted value of the accrued benefit on his retirement.

Once design has been established and the objective has been set, we must then consider how to satisfy the above requirement that the trustees set strategic asset allocation " with respect to the nature and duration of liabilities" in the context of a DC scheme.

We take this to mean that, in a DC scheme, the nature and duration of the liabilities is related to the age of the member (or their proximity to normal retirement).

The range of funds available within a DC scheme should address the different risks that members will be faced with over the course of their working lives. We have identified three main risks for members when considering investment strategies:

q Real growth risk - the risk that the investments will not achieve a return sufficiently above inflation to secure an adequate benefit. This is the main risk members face over the long term.

q Capital risk - the risk that the investments suffer a fall in value. This becomes more important closer to retirement, when there may not be sufficient time to make up any losses in fund value.

q Pension conversion risk - the risk that as a member approaches retirement, annuity rates move against the member, thus reducing the pension purchased.

In addition the trustees should also consider the following risks associated with the investment arrangements:

q Manager risk - the member is exposed to the actions or decisions of the investment manager.

q Failure to meet investment needs - the risk that members choose inappropriate funds, or that the number and type of funds offered is sub-optimal for the needs of some members.

The trustees must set out how they will measure and manage each of the above risks in their SIPP. In managing these risks appropriately, the trustees can state that their investment strategy has been set with respect to the ‘nature and duration of liabilities'.

In conclusion, the changing regulatory regime has led to more critical thinking in the management and ultimately the design of DC pension schemes. In some cases this process has resulted in scheme design being more critically evaluated. In all cases it has resulted in the trustees taking a fresh look at their approach to the management of the scheme and the risk inherent in it. Members will be the beneficiaries of the changing tide.

Deborah Reidy is a director of Hewitt Associates in Ireland.