The UK trend from defined benefit to defined contribution schemes is expected to intensify with the advent of auto-enrolment and to trigger innovation in investment options, finds Nina Rohrbein

In 2001, stakeholder pensions were introduced in the UK. These required employers with more than five staff to facilitate a pension scheme and allow members to make contributions through the payroll.

However, most employers were unwilling to contribute, so employees did not see the point in joining such defined contribution (DC) arrangements, many of which became empty ‘shell' schemes. At the same time, driven by factors such as stricter regulation, changes in accounting rules, worsening investment returns and increasing longevity, the transition from defined benefit (DB) to DC began to take hold.

According to the National Association of Pension Funds' (NAPF) latest survey of its members, only 19% of DB schemes in the private sector remained open to new members in 2011, while the proportion of schemes also closed to future accrual for existing members tripled over the past three years to 23% in 2011. Among those pension schemes that are closed to new staff but still open to existing staff, 30% expect to close the pension altogether in the next five years and plan to move staff into a DC scheme.

The last FTSE 100 company - Royal Dutch Shell - closed its DB scheme to new entrants earlier this year.

The size of the UK DC market is estimated to be around £557bn (€690bn), compared with a DB market share of £5,389bn although, according to Gurmukh Hayre, head of DC pensions at KPMG in the UK, nine out of 10 employers offer DC plans. "There is a very small fraction of schemes left which are still open to future benefit provision on a DB basis, although in the public sector DB provisions still dominate," Hayre says.

"DC pensions have become the preferred choice, and most new pension arrangements are now contract-based stakeholder or group personal pensions," adds Neil Latham, principal at Punter Southall.

In terms of regulation, a lot depends on whether a company is operating a trustee-based scheme. According to Hayre, the balance between trust-based and contract-based DC schemes is around 50/50 with contract-based schemes increasing, highlighting a shift from DC schemes with trustees to those that are run by employers using trustee boards.

There are around 15 established contract-based providers in the UK, plus new entrants such as the National Employment Savings Trust (NEST), Now Pensions and the People's Pension, which makes the UK contract-based DC market very competitive.

Trust-based DC schemes are governed by trustee deed rules and the Pensions Act, which sets out how the trustees should administer the scheme and how contributions have to be paid into the plan. But for contract-based schemes there is no similar compliance framework. They are essentially individual policies or plans set up with a provider under an umbrella arrangement and fall under the authority of the Financial Services Authority (FSA).

But the UK regulator now seems keen for all DC schemes to be properly governed and have some oversight responsibility. It has been advocating best practice over the past few years in areas where it feels employers and trustees should exercise more diligence, such as transparency, administration, charges, investment options, and the support made available to people when they approach retirement.

"Because of the trend from DB to DC in the UK, and with it a shift of risk from employer to members, there is a need for some innovation in investment design to bring more certainty to the potential outcomes for members, such as deferred annuity-type concepts," says Hayre.

The vast majority of DC schemes, around 80%, use a lifestyle approach to investment in their default funds. The main issue with lifestyle funds is that they are not diversified enough and therefore likely to carry too much risk. Many of them are vanilla approaches that invest in global equities in the growth phase and five years before retirement move into bonds - and Hayre believes this one-size-fits-all lifestyle strategy is not the right approach.

"You need to have a different lifestyle, which starts to phase assets from 10-15 years out with a gradual shift and also a more diversified approach, including a broader range of asset classes," says Hayre. "This is starting to happen in the UK more and more, particularly with the larger companies, which in the end will filter down into the middle market. Smaller companies probably need a simple approach.

"As the DC market changes over the next few years, we are likely to start seeing investment ideas being developed that have a closer match to how members take their benefits when they retire, as not everyone will buy an annuity in the future. At present, many retirees still buy annuities with a provider that offers them poor value."

"Everyone used to go for cheap, passive investments within a lifestyle profile but because these are normally 100% equity and relatively volatile, they are too risky for many members and did not cope well in 2008," adds Latham.

Modern solutions are returning to the multi-asset approach of the traditional managed fund but with some important improvements. While a traditional managed fund had a static asset allocation with perhaps 70% in equities, 20% in bonds plus some property and cash, modern funds are much more dynamically invested. They tend to hold less in equities, more in bonds and up to 20% in alternative assets. These include financial instruments that help hedge against the investment risk, producing smoother returns.
Auto-enrolment, due to start with the largest employers in the autumn of 2012, with the smallest ones staggered until 2017, is expected to widely increase DC assets under management, with an estimated 6-9m people being automatically enrolled into pension schemes.

All the evidence so far is that companies with DC schemes are generally looking to use their existing schemes to fulfil their auto-enrolment duty. They are not looking to stop these and necessarily use NEST or equivalents, Hayre believes. "They may be looking at changing in some shape or form, but certainly the medium-sized and larger ones will use their own schemes for auto-enrolment, while the large number of small and micro-employers will be the beneficiaries of using NEST or other players in the UK auto-enrolment market," he says.

"Auto-enrolment will give DC pensions critical mass," adds Latham. "The influx of potential new members means that DC pensions are becoming much more supervised arrangements. The Pension Regulator (TPR) has been given responsibility for workplace pensions and although DC schemes enjoy lighter regulation, auto-enrolment has changed the landscape.

With auto-enrolment, the government plans to phase in the level of employers' contributions, rising from 1% initially to 2% in October 2016 and 3% a year later. Employees will have to pay in 1% in contributions before October 2016, 3% the year after until October 2017 and 5% from October 2017.

The 2011 NAPF survey showed a current average combined employer and employee contribution total of around 12%.