You have been warned - now is the time to examine DC schemes

With stock markets around the world getting into the habit of losing 5% to
10% of their value in one day and sometimes making most of it back the next,
it’s hardly surprising to find employees worried about the impact of all this
thrashing around on their pensions.

Now, in other words, is the time for companies to really examine and improve
the way they communicate to employees about their occupational pension plan.

There are at least three major, self-interested reasons for doing so, quite
apart from the fact that it is the right and proper thing to do. First,
companies do not gain by having their staff in an anxious and concerned frame of
mind. Second, companies provide a pension at a very substantial cost to
themselves: if it is going to invest in a benefit on that scale, then it is in
its own interests to see that the benefit is recognised and valued by the staff.

Third ­ and this is the really interesting one ­ there is a storm brewing, in
the shape of litigation to come. Companies that say the right things in print
and do the right things in practice will have a better defence to fall back on
than companies that do not.

Ironically, the litigation risk arises from the defined contribution schemes
that employers have turned to as a way of shedding their final salary financial
risks.

Individual responsibility
The nub of the problem lies in the fact that, with DC schemes, each individual
is responsible, in effect, for defining the investment strategy for their
particular pot of money. As David Robbins, public policy adviser with
Watson
Wyatt points out, this might look as if the company is home free,
irrespective of how the investment performs. However, the reality could be very
different.

Consider a very probable future in which DC scheme members find that their
pot of money is manifestly not enough to provide them with anything other than
miserably skint old age. Will they accept that under the logic of the shift from
DB to DC schemes, the responsibility for the scheme’s failure to produce a
sufficient pot of money lies with them?

Some might, more might not. They will take the matter to their lawyers who
will cast around for a way of attaching blame to the company. Taking as their
starting point the employee’s claim that they were “misled” about the probable
size of their ultimate pension, the lawyers may want to attack the company on
the grounds that it failed to adequately inform its members of the nature of the
transfer of risk entailed when the company moved from DB to DC.

The starting point for any judge in an action like this will be an aggrieved
plaintiff who really is ­ no question about it ­ staring at stark poverty and
who has a multitude of similarly-aggrieved scheme members waiting in the wings
for their actions to begin. The judge, one might respectfully suggest, is not
going to be disposed to regard the company, whose actions without question
initiated the sequence of events that led to this state of affairs, as entirely
blameless. In fact, as Chris Noon, a partner
with
Hymans Robertson notes, any company which finds itself in this
position is going to want to be able to put before the court a really strong
history of excellent communications with its employees on the subject of DC
schemes.

Communication strategies
So far, however, all is not well on this front. The problem, Noon says, is that
while a number of finance directors in larger companies have got rid of their
risky DB schemes, they have so far failed to make the necessary investment in
their DC scheme. By this he is not referring to the employer’s contribution to
such schemes ­ which, indeed, is often too low for the scheme to produce a
decent pension ­ but to the fact that they are not investing enough in
communications strategies to arm employees to cope with the new responsibilities
they are taking on.

“The point about DB schemes was that, from an organisational standpoint, the
employer did not have to worry about them. The trustees and the trust framework
provided a coherent infrastructure for these schemes. With a DC scheme on the
other hand, the employee is pitched into the fray and courts may well decide in
future that the employer had a duty to explain what this shift of responsibility
entails,” he suggests.

At present, neither the recruitment process, nor the induction process, nor
the line manager support function, is geared up to alert a new employee to the
perils of making the wrong investment decisions in a DC scheme.

How is Noon so sure that not enough is being done? He points to the
statistics. “In many companies where there used to be 100 % of employees signing
up to the DB scheme, there are less than 10% signing up for the DC plan. And in
many instances this is not because the plan is bad or not generous, but because
the company is not supporting the employees coming into the DC option,” he says.

Noon offers the analogy of a mythical corporation that has a long history of
sending chauffeur-driven vehicles to ferry staff to and from work. If it
suddenly switched to providing them with their own cars, without ensuring they
had any driver training, there would be a spate of crashes. “With our car
example, the crash happens pretty soon after the switch. With pensions, the
crash comes 40 years later,” he says.
The moral of the story is that companies need to add comprehensive DC
“instruction” to their induction process for new recruits. And yet, they cannot,
of course, offer financial advice, just general advice, such as the importance
of “life-styling” the investment policy.

“Having joined the DC scheme, the new recruit becomes, in effect, their own
fund manager, so they need the skills to select the appropriate funds from the
often opaque list of funds that they can choose from,” he says.

Dave Robertson, a partner within Mercer’s financial strategy group, takes up
the theme of DC schemes and the current market turmoil. He argues that where a
DC scheme has been designed to give due consideration to risk, and there are
developed strategies in place to ensure, for example, that members are
progressively moved out of equities as they near retirement, any communications
from the company to the members right now could be fairly reassuring. “You would
be saying that while these are difficult times the DC plan has structures in
place to enable the members to manage their way through the problem,” he says.

The ideal position here is where members have been sufficiently educated in
the notion of risk and reward and in assessing their own appetite for risk.
“Clearly, choosing the investment strategy is ultimately in the hands of the
member. If they have opted for some exotic investments, there are going to be
fund options in the menu they can choose from which would create difficulties
for them in the current downturn,” he says.

Member confidence
Similarly, in a DB scheme, where there is a strong employer covenant, to the
point where the membership can be confident that the employer will be able to
ride out any downturn, the message to the scheme members is likely to be quite
positive even if the scheme has quite a high equity exposure. After all, buying
equities when they are cheap makes excellent sense if you take a long-term view
and are reasonably confident that equity markets will recover. (This is less
certain than it might seem ­ Japanese equities are still well below the values
they enjoyed before their bubble burst more than 18 years ago.)

However, where a DB scheme has a high equity content and an employer who is
being buffeted by the present conditions, then soothing words from the trustees
to the members could be extremely difficult to do right now. But the trustees
cannot shirk the responsibility to report to the members: “They have a duty to
communicate, but the messages that go out will be quite negative,” Robertson
says.

Back to DC schemes and Robertson agrees there is definitely potential for
future legal action around poorly performing funds. “Where these schemes have
been badly deflated by the crash in equity values, and where members have
colleagues and friends who are with the company’s DB scheme, there is the
potential for members of the DC scheme to feel particularly exposed and
concerned,” he says.

Initially, Robertson suggests, this is more likely to take the form of calls
from the unions and from members for employers to step up and help members of DC
schemes. However, one cannot rule out some legal challenges based around the
idea of misleading communications from the company about the DC scheme.

“It is far from obvious to me how such legal action would play out in the
courts,” Robertson says. “There is no doubt the DC scheme puts the risk on the
members. But might the courts decide that, nevertheless, the risk somehow
returns to the company? The only grounds for such an action would seem to be
miscommunication, so the defence must lie in the company making sure that the
members are fully apprised of all the risks involved in various investment
strategies.”

It may be that some companies will decide that the simplest forms of DC
schemes ­ those that leave it all up to the member ­ are not appropriate, after
all, and that they should engage in a degree of risk-sharing with members. The
government is currently exploring the possibility of such hybrid schemes.

Watson Wyatt’s Robbins points out that even DC schemes that have a default
‘life-styling option’ that moves members out of equities and into low-risk bonds
as they approach retirement could have a problem: members who do not take the
default (and so who end up exposed to too much volatility risk just prior to
retirement) might argue that the virtues of the default scheme were never
properly explained to them.

Robbins also argues that companies with DC schemes should be telling their
members that the money stays in a protected pot and is not reliant on the
strength of the employer. This can be a crucial point in a deep economic
downturn.

The main lesson for finance directors to take from all of this is that DC
schemes are not just a way of bailing out of expensive DB schemes. They impact
people’s quality of life in retirement and if you short-change your staff on
this, expect trouble later.