Bobby Riddaway of the Finance and Investment Board considers the impact of the budget changes announced in 2014 on the provision and management of defined contribution schemes and looks at the issues that trustees and providers should be considering
In summary, the majority of retirees from defined contribution (DC) schemes will have three choices at retirement. These options include, but are not limited to:
? taking 100% of their accumulated fund as cash (note that 25% of this amount can be taken as a tax-free cash lump sum, with any balance over this amount incurring tax at the member's marginal rate);
? purchasing an annuity; or
? a combination of the above, including leaving cash invested and drawing down cash in trenches.
The current situation compels the vast majority of members to purchase annuities with 75% of their fund. For trust-based DC schemes, the overriding objective for trustees is to ensure the best outcomes for members. In addition to meeting their fiduciary duties, trustees must operate within the boundaries of their scheme's trustee deed and rules. Trustees can help members achieve the best outcomes by concentrating on good communication throughout the scheme's term.
One of the overriding factors that will affect outcomes is a member's investment strategy. A balance needs to be made between having too many options that members won't be able to decipher and having too few, restricting the choices members can make. Typically, between 80% and 90% of members will invest in the default strategy offered rather than the self-select funds on offer.
In general, the self-select range of funds should not be too extensive, as this could dramatically increase the trustee governance requirements. However, the additional flexibility that members will now have at retirement means that current default strategies, which typically target taking cash and purchasing annuities at a normal retirement age, will not be appropriate for some of the choices that members will make. In addition, income drawdown has not generally been offered within schemes, and most schemes probably will not want to administer it in the future.
What has been or should be the immediate response to this? Most, if not all, default strategies have been designed to target the purchase of an annuity. If, as expected, a significant portion of those funds that were historically used to purchase immediate annuities are now used for other means, the default strategy is inappropriate. While it is not possible to predict member decisions, an analysis of the demographic and financial position of the membership can assist in the choice of an appropriate default strategy. It may therefore be appropriate to review both the membership of the scheme and the investment options available - including the default. Trustees should be aware of potential resource issues if large numbers of schemes are trying to complete DC reviews at the same time. This could affect the ability of both advisers and providers to meet deadlines.
Members should have flexibility and choice to tailor their saving plans to their specific risk appetites. However, budgets are constrained and greater scrutiny is being placed on scheme governance - not least by the Department for Work & Pensions, The Pensions Regulator and workplace pension NEST, which have all been promoting the importance of DC governance. A chairperson's statement will have to be available on an annual basis, covering default funds and trustee knowledge and understanding. Trustees may rebalance their budget to focus on governance at the expense of other items, such as active investment management.
A typical membership analysis can establish the proportion of members who are willing to engage in their investment choices, either fully or in a limited way, and those that will always go for the default. As the choices are now three-fold, the proportion of members taking the default is expected to decrease. Going forward, an analysis of a scheme's membership will naturally dovetail with reviewing a scheme's investment strategy; both in terms of the number of options to offer, and which options are most appropriate.
The analysis will also help to determine what changes are required for current default strategies and how this should be communicated to members. While it is unlikely that a full review can be performed and communicated before April 2015, it is important to communicate to members the objectives of the current default strategy and what it was designed for. It would also be advantageous to find out which members could be affected in the short term, ie those close to normal retirement date or those close to age 55.
Additional strategies could be considered as long as they are communicated effectively - but it is unlikely that smaller schemes will have the governance budget for this. It is even more important, therefore, that they focus on communicating the objectives of the current default and signposting the options available to members at retirement. A priority for trustees should be to make default strategies more robust to handle all three retirement choices.
In the medium term, the market will continue to evolve and the experience of members' decisions will be forthcoming. Trustees should recognise that anything they do now should be reviewed in two to three years once this extra information comes in and potential extra products have been launched.
Recent regulatory changes now mean that it is important for trustees to consider the process through retirement - even if they do not offer any facilities 'in scheme' post-retirement. It is also important to recognise that pensions form part of a member's long-term savings and tax planning. Employers may wish to place great emphasis on member communications and take the opportunity to look more holistically at pensions in the context of total reward.
In conclusion, from April 2015, members will have greater flexibility at retirement and trustees will need to reassess the objectives of their scheme from first principles. They have a duty to ensure best member outcomes, so an analysis of the membership and a change to the investment strategy will probably be appropriate. DC pensions are no longer pensions - they are long-term saving plans and members should take charge of them alongside their other finances.