Decision time

When employers want to establish a defined contribution (DC) pension scheme, they must obviously decide whether to choose a trust-based scheme or a contract-based scheme.

Although the government’s new simplified tax regime has removed any tax differences between trust and contract-based schemes, there still remain many other important differences that employers must consider. But the main consideration is that if they choose a trust-based arrangement, the employer is forced to comply with all the complex requirements of the Pensions Acts.

If they chose a contract-based arrangement, on the other hand, it is the pension provider that takes responsibility for all the corresponding administration, including compliance with legislation and the provision of scheme documentation. Contract-based arrangements are also less expensive to run.

What are the advantages of trust-based schemes?
Trust-based schemes offer four main advantages:
• It is easy to install a DC scheme under an existing defined benefit (DB) trust.
• Trustees are well equipped to provide their members with investment guidance.
• It is easy to change corresponding providers.
• There is greater scope to customise scheme-related services and communication.

Making the DC arrangement part of an existing DB scheme
A DC arrangement may replace, or run alongside, a DB scheme. A DC section can easily be added within the same trust, and, as Pension Act regulations already apply, the DC section does not add any extra responsibilities.
Another advantage of running a DC arrangement under a DB scheme’s trust is that a surplus in the latter can be used to pay the DC contributions (subject to the scheme’s trust deed and rules).

Employer monitoring and control
With significant amounts spent on pensions, it makes economic sense to monitor how funds are used.
With a trust-based scheme the employer is proactive in scheme design and investment strategy, and provides communication and guidance to employees through a trustee body. Trustee boards tend to be more knowledgeable about pension matters than members.
They are equipped to pay for professional advice, and are able to make important decisions about the selection of the investment manager and provider, and about their regular review (though, in the case of contract-based schemes, employers can set up a monitoring body if they feel employees need more guidance or support).
It would be wise at this point, however, to remember that any trust-related responsibilities increase potential liabilities on the employer.

Easier to change providers
As trustees are appointed to make important decisions in the interest of members, pension providers (i.e. pension administrators and investment managers) can be changed without all members consenting.
In the case of a contract-based arrangement, such changes require the consent of all members, particularly if the old scheme’s benefits are to be transferred.

Refunds
Trust-based schemes can refund member contributions to leavers with less than three months’ service. And if they have more than three months’ service, but less than two years’ service, the member is offered the choice of a refund of member contributions or a transfer of all their benefits. (Employers have no responsibilities toward early leavers under a contract-based scheme.)

What are the disadvantages of trust-based schemes?
The downside of trust-based schemes relate primarily to the particularly onerous regulatory responsibilities placed on trustees and employers, who are subject to complying with the Pensions Acts, scheme rules, and laws relating to trusts. Here are some examples of the complexities:
• The requirement to comply with rules on member-nominated trustees.
• The setting up and maintenance of an internal dispute resolution procedure.
• Scheme registration, scheme-levy payments (and compensation levy, if any) each year.
• The appointment of a scheme auditor.
• The production of annual trustees’ reports and, unless an earmarked scheme, audited accounts.
• The requirement to comply with disclosure of information rules.
• Record keeping
• The requirement to comply with rules on trustee meetings.
• The requirement to comply with self-investment principles (unless a wholly insured scheme).
• The obligation to whistle-blow to The Pensions Regulator if any breach of any statutory requirements is discovered.
And there are more headaches. For example, trust-based defined contribution arrangements are subject to the principles put forward in the Myners Report, which changes the “prudent man test” to a “prudent expert test”.
This places greater burdens on trustees in the context of investment issues. These principles are now contained in the Pensions Act 2004. Trustees are required to have:
• Knowledge and understanding of the law regarding pensions and trusts.
• An understanding of the principles regarding occupational pension scheme funding, and asset investment.
Trustees need a more “hands-on” approach to investment issues, including careful monitoring of investment funds and surveys of members to ensure they have the ability to understand and manage the risks associated with their scheme. It is becoming increasingly difficult for trustees to defend themselves – according to reports, the cost of trustee-negligence cover has increased in the last 18 months.

What are the advantages of contract-based schemes?
The advantages for an employer of contract-based schemes can be summarised as follows:
• No responsibility for governance (the pension provider is responsible). All the employer has to do is ensure contributions are paid on time.
• No Pensions Act responsibilities.
• The employer is not affected by European Union occupational pensions directives.
• No responsibility for investment performance.
• Reduced running costs.
• Less risk for members because of the direct contract between them and the provider.
• No need for trustee boards, trust deeds, or an understanding of scheme rules and legislation.

Investment issues
With regard to the investment side of contract-based DC schemes, there are even more advantages:
• The employer can choose the provider.
• They are not responsible for the provider’s fund performance (progress checks should however be made).
• For a stakeholder scheme, the employer is exempt from any liability for designating a particular provider.
• Most providers offer wide ranges of investment funds from internal and external managers.
• Members can choose and adopt their own investment strategy. If investments do not match expectations, the employer is not responsible.

Costs
Contract-based DC schemes reduce employers’ costs. Direct costs are reduced, such as those corresponding to external consulting and administration fees, and indirect costs are lowered, too, such as those associated with management time lost to pension scheme-related administration, and trustee costs.

The protection of the employer and the members
In a contract-based scheme, the active relationship is between the member and the provider. That means employers are less liable should the provider fail to deliver.
Members are also better protected if the employer becomes unable to sponsor the scheme. Winding up a trust-based scheme can take many years, and even then members may not receive full benefits, but a member of a contract-based scheme is not dependent on their employer’s future solvency and so is better protected.
Early leavers do not signify any refund responsibilities for employers in contract-based schemes.

Annuities
Contract-based schemes remove the worry of annuity purchase because the member purchases an annuity directly with a provider, in the style that suits them best when they reach retirement.

Conclusion
The main issue facing an employer starting a DC scheme is how much administrative responsibility to take on behalf of their employees. Some employers feel it is not enough simply to pay pension contributions; they would prefer to become more involved, and spend greater amounts of time and money to ensure members get maximum benefit from the pension scheme set up on their behalf.
Other employers, however, feel that while they would like to give employees the means to provide for their retirement, they would prefer to let the employees themselves take control of their finances.
The pendulum is swinging towards contract-based schemes, which are quickly growing in popularity. And for those employers that prefer to have a higher degree of control, there is always the self-branded GPP, a product that allows them to introduce some customisation while avoiding the additional burden of trust-based structures. π

Andy Savage is senior consulting director at Jardine Lloyd Thompson Benefit Solutions