Switch to DC poses real problems

The UK has a long history of defined benefit (DB) pensions, but in recent years many employers have switched to defined contribution (DC) schemes, particularly for new members. As the requirements are different for each of these arrangements, changing from DB to DC presents companies with administration and governance challenges.
A fundamental governance decision for a new DC scheme is whether or not to set it up as a trust. Schemes established on a contract basis are primarily the administration provider’s responsibility (though employers need to notify providers about employment termination as well as deduct contributions and pay them to the provider). Regulatory restrictions apply on what employers may communicate about a contract-based scheme.
Schemes set up on a trust basis are fundamentally the trustees’ responsibility. It is possible to set up a new DC scheme within an existing DB trust, making use of existing governance arrangements. This is particularly an advantage for smaller employers that would otherwise see the cost of DC trust-based governance as an additional burden.
Although some employers prefer to have trustees in place to provide governance, others wish to avoid it in order to emphasise that the scheme belongs to employees. It is important to bear in mind that poor administration will devalue a scheme even if investment performance is good.
Over the past three years, the Capita Hartshead survey of UK schemes
has shown that around a quarter consider their administration to be inadequate. So, these issues clearly need attention.
A key question in a new DC scheme is the identity of the scheme administrator. For UK DC schemes there are basically three options:
q The investment manager (or their administration subcontractor or alliance partner) who can provide most scheme administration services in a “bundled” arrangement.
q A third-party administrator (TPA).
q The employer can administer the scheme in-house.

Bundled administration
The UK DC administration market has been transformed in the past two years by the introduction of stakeholder pensions. Insurance companies invested heavily to develop efficient computerised administration systems. This technology investment has now been used to produce administration platforms for occupational DC schemes, with several providers offering products with ‘bundled’ investment and administration, with charges based on a percentage of the fund. Many providers now include ‘guest’ funds from other investment managers within their investment options.
Bundled services are conceptually attractive, combining closely related functions, and the systems are impressive, offering web-based member information. According to Mercer’s 2002 Global Defined Contribution Survey, over 60% of DC occupational schemes set up since April 2001 have been established on a bundled basis.

The main downside of the bundled approach is that it is necessary to change administrator when switching investment manager. The scope of administration service available is also limited – providers prefer to restrict services to those that link to the computerised investment processes, so various residual services (for example, bank account management, preparation of scheme accounts, submission of tax forms, purchase of annuities) require others’ involvement. However, an existing DB administration function could be used for these ancillary tasks.

Third-party administration
An alternative is to establish an ‘unbundled’ arrangement with a TPA. TPAs typically charge on a per-member and per-event basis rather than as a percentage of fund, but offer a full service. The unbundled approach offers an unrestricted choice of investment managers, and TPAs claim to be more accommodating of the way clients want to work than bundled providers. For a trust-based scheme, the unbundled approach (or, alternatively, in-house administration) may better suit employers who want more hands on involvement and a closer tie between company and scheme. However, charges tend to be higher, at least initially, than under the bundled route, and this approach introduces another player and an additional aspect to administration and governance processes.

In-house administration
The third option is to administer the scheme in-house, and the technology is now available to support this. The decision as to whether to take this approach will depend on the company’s view of in-house versus outsourced operations, and its resources in terms of the necessary technology and technical knowledge.
If the bundled or TPA approach is chosen, the next question is which provider? Selecting a bundled provider is a joint investment and administration decision, and expert input is advisable to reflect good governance.
Selecting a TPA is often done through a tendering process, and factors to consider include commitment and financial strength, resourcing and capacity, service model and IT offering, client references, staff training and implementation approach.
The tendering and implementation process may take six to nine months, starting when the scheme design has been defined. From a governance stance, it is recommended that the tender process is completed satisfactorily, with future procedures in place for regular audits and reporting.
One of the most important administrative challenges is to ensure good links from employee payroll to the administrator, particularly where there are multiple payroll functions and systems or known problems with payroll processes. The most vital aspect is the core DC processing, that is, collecting contributions and data, allocating contributions and investment to individual members’ records, and rigorous reconciliations throughout to ensure that the process remains error free.

It is important that the chosen administrator is proactive in the implementation of the scheme and that the demands on employee payroll are met. In terms of governance, project management should be tight throughout the implementation process.
Transfer of DB data may need to be considered for members switching to future service in the new scheme. DC scheme members increasingly expect on-line access to their records, so it is important that these are accurate and up-to-date.
Rules and processes should be built into the payroll or administration system based on the following considerations:
q As well as the determination of employee and employer contributions, what salary basis will be used, and how will changes in contribution rates be dealt with?
q How will new entrants and leavers be notified to the administrator?
q What contribution levels will be used for those on secondments or maternity leave and those on temporary/rolling contracts.
The larger the scheme, the more important it is that proper procedures are developed for these matters.
An important point to remember when introducing a new DC scheme is what information is given to employees in the recruitment process before the new scheme is introduced.
Recruiting managers will need to know at what date new hires will no longer be eligible to join the DB scheme and only the new DC scheme can be offered. A general communications programme will be required to explain the new scheme to all eligible employees (there are statutory requirements about this).
Unlike DB plans, DC schemes do not tend to have risk benefits included. They are usually arranged separately as there will be no fund reserves to cover them.

Afurther aspect of DC administration that is very different from DB is that members’ account balances are normally used to buy an annuity on the open market at retirement. Though there will probably be few retirements in the early years of a new scheme, it is important to make appropriate arrangements for governance and administration purposes.
In trust-based DC schemes, trustees are required to provide an outline of the types of annuity available and an indication of where information and advice can be sourced, but they cannot offer advice on the precise type of annuity. Members should not be left entirely to their own devices in making decisions on annuity type (for example, increases and spouse provision).
Once established, DC schemes require maintenance and monitoring – it is not a case of ‘set up and forget’. It is important to monitor
the scheme’s development to ensure that it meets employee needs, that employee investment choices are reasonable, and administration services are satisfactory and fairly priced.
Finally, according to Mercer’s survey, the most successful DC schemes have a service agreement with their administrator, have documented
and rigorously monitored service standards and periodically have an independent operational audit of the quality of service and of record keeping.
Robert Plumb is a European partner with Mercer Human Resource Consulting, based in the UK

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