Weighing the cost of outsourcing

We may be in the post pensions simplification era, but scheme managers could be forgiven for wondering where the simplification part comes in.

For many managers, whether to keep scheme administration in-house or whether to take the plunge and outsource to a third party is a continuing dilemma.

This article sets out to canvass the views of administrators and consultants as to which schemes should operate their pensions administration in-house and under what circumstances schemes should outsource, considering the pros and cons of both approaches.

Cost is – or should be – a key consideration when deciding which administrative route is best for a pension scheme. But is that all there is? What other factors should drive the decision?

Perhaps the best place to start is with the regulatory and legislative challenges that may be driving schemes to consider third party administration.

Cost is raised as an early determinator. Capita Hartshead research reveals that, following the government’s simplification measures, schemes of around 10,000 members have typically spent around £150,000 on implementing those changes. Capita Hartshead client services director Clive Wickenden says lower costs have been associated with complying with the Pensions Act 2004 and recent age discrimination changes, although some larger schemes report spending up to £3-4m on the implementation of age discrimination changes.

He says: “It is clear these changes are affecting decision-making. In our research, in-house administered schemes state that changes to pensions legislation were more likely to cause them to consider outsourcing administration, suggesting the recent rash of legislation could result in more and more schemes opting to outsource their administration arrangements.”

The impact of legislation on driving administration out-house continues agrees Watson Wyatt head of administration consulting Paul Mead. He explains that for some schemes the Finance Act 2004, which added new demands to the administration of schemes, was the final nail in the coffin as far as continuing with in-house administration is concerned.
He says: “As trustees undertake reviews of their internal controls, they may find systemic issues in the administration that suggest to them they should review whether a third party administrator might be a lower risk option for the administration of their scheme.

“Pensions legislation and regulation are both encouraging trustees to monitor the risks they face in running a pension scheme. They may consider that outsourcing the administration of their scheme passes some of the risks inherent in the administration to a TPA.

“Ultimately, however, I think it may well be the increasing demands and expectations of defined contribution members – who as the quid quo pro of taking on their own investment risk seek greater control of their investments – that drive some trustees to consider outsourcing the administration and passing on this technological burden.”

Higham Dunnett Shaw head of consulting Ian McQuade says: “It is the constant stream of legislation and regulation, as opposed to specific changes, that is driving outsourcing. As the government continues to make changes, many trustees decide they would like someone else to take the worry about making sure they are compliant with the changing legislative environment. This also helps them to share the costs of ensuring ongoing compliance.”

The impact of legislation and regulation on in-house administration is not just a question of shoving administration out the door and making it another’s responsibility, however. JLT Benefit Solutions commercial director Malcolm Reynolds says the current changes prompting schemes to consider outsourcing include better management information from administrators to ensure schemes are being run properly and in accordance with legislation, and The Pensions Regulator’s codes of practice on internal controls.

He says: “Trustees now have to know what controls they have in place and what mitigating action they should take to ensure those controls are enforced and updated accordingly.”

Why stay in-house?
While regulation and compliance can be key reasons for many schemes to consider outsourcing, there remains the question: which schemes should still keep pensions administration in-house?

“Smaller schemes find that outsourcing their administration alone can be prohibitively expensive,” says Wickenden. And according to Capita Hartshead’s Annual Pension Scheme Administration Survey 2007, schemes with less than 2000 members could save an average of £2 per member by administering benefits in-house.

Wickenden adds: “However, it is often the case that small schemes will outsource their scheme’s administration via a bundled arrangement, including consultancy, actuarial and sometimes investment services, as well as administration. This has the advantage of reducing the management time spent on scheme administration, allowing management to concentrate on core business activities. Bundled services maximise the expertise available to the scheme, as well as providing greater cost savings than standalone services.”

Cost, Wickenden says, is not the main reason cited by in-house administered schemes for continuing their current administration. Rather “improved control of administration” was found to be the most popular reason for retaining in-house administration, followed by “reliability of service” and “greater efficiency”.

But, Wickenden says: “Many of the smaller DC schemes now choose to use a TPA simply because of the volume of work involved in administering these pension schemes.”

Of course it is not just the case that a small scheme should outsource; Mead says company culture plays a large part. Some scheme sponsors want to maintain control over administration, so that scheme members can address pension issues with the company they work for – not with someone they don’t. Mead is not convinced by this argument, however; he points out even the in-house pensions administrator may work in a different office to the member with the query.

He says: “I think a more significant advantage to in-house administration is where the in-house department is providing more services than just core record-keeping and benefit calculations.

“If the pensions department add value by, say, conducting pensions surgeries or are providing some other services that may not be easy to cost effectively outsource, such as some HR activities (personal health insurance, redundancy calculations, etc.), this may suggest that in-house administration is more appropriate.”

Another consideration, Mead says, could be confidentiality. And there is the concern that while in-house staff are focused on the one scheme, TPAs have other clients making demands on their time as well.

This single focus is a common theme for industry pundits, but it ties in with other issues. Size, of course, can matter when dealing with pensions administration in-house. But for many schemes this is still also weighed against what Reynolds describes as the paternalistic approach to dealing with employees.

He says: ”Organisations need to be large enough to be able to maintain a department of sufficient critical mass that is able to invest in technology, process change, technical support and staff development for the foreseeable future. But the major advantages for these organisations are that the business maintains strategic control over the types and standard of services offered, it holds the corporate identity, and offers a personalised and customised service – focused on one scheme only with no distractions from other schemes.”

Another factor, which may or may not depend on the size of the scheme or the scheme sponsor, is how the membership of the scheme is comprised. McQuade says regardless of company culture and whether the company has an outsourcing approach to other non-core functions, the maturity of the scheme can be an issue, so that an internal function is working to deliver services to people who are either pensioners or now work for other companies.

He says: “In some cases, when the number of active members becomes as low as 10pc or 20pc of the total membership, the company may decide to outsource and focus its own resources on matters that add more to its own success.”

When exploring other reasons why companies may want to keep administration in-house, cost seems to inevitably rise to the surface as a consideration. Gissings’s head of client management Ravi Khanna makes the point that the move to DC pension provision means that, even for the largest employers, in-house pension administration is still a viable option.

He says: “Provided the employer is willing to invest in the latest technology – in particular, the move to web-based access for scheme members – member expectations, especially in terms of turnaround times for information, has increased dramatically. For scheme sponsors willing to embrace and finance these changes, in-house administration
is still the answer.

“In-house provision clearly can deliver closer control of administration activities for employers. This control needs to be weighed up against the need to continually invest, to ensure administration processes and systems are able to provide an appropriate level of service to scheme members.”

The advantages of outsourcing
So, having considered some of the reasons and points to bear in mind when keeping administration in-house, what are the advantages to outsourcing?

Continuing the cost (and size) argument, Capita Hartshead’s research found that for schemes with 2000 or more members the cost of third party administration was noticeably cheaper than in-house administration. However, Wickenden says, as with in-house administered schemes, cost was not cited as the main reason for continuing in TPA arrangements.

He says: “Having specialist staff is a popular reason to outsource, perhaps reflecting the need to implement new and complex legislation. Also, reliability of service was ranked as the second most important reason for continuing with the current outsourced arrangements. Both of these factors were also reflected in the reasons for choosing one specific TPA over others.”

There are contradictions when totting up scheme sponsor size and resources and scheme size and maturity as arguments to outsource. While larger schemes may be able to make savings outsourcing, this is not to say smaller schemes need to keep things in-house. Mead says there is an argument to be made that good quality DC administration is hard to achieve in-house unless the scheme is of such a size that it is possible to invest heavily in very robust systems and processes, with specialist staff.

He says: “More generally, there can be advantages in terms of reducing head office headcount. Also, by outsourcing you are removing the problems associated with finding good quality staff; maintaining complex software and processes and amending systems in line with legislative changes.

“These can be a particular challenge to smaller schemes. I think it unlikely, therefore, that I would recommend to a client starting a small scheme from scratch that they perform the administration in-house.”

Keeping up with changing circumstances
The decision to outsource (or keep administration in-house) needs to be regularly reviewed as schemes mature and become larger or smaller, or the circumstances of the employer-sponsor change.

Reynolds says there are a number of definable points in time within the existence of a pension scheme when it becomes best to outsource. These include:
• The diminishing size of the active membership (as schemes close to new employees);
• The complex changes in legislation which require wholesale changes to practices, procedures, systems and staff education;
• When a scheme is in wind-up;
• When key employees leave or there are resource constraints;
• When investment is required in, for example, technology, which may be outdated;
• When businesses change their focus on core activities or there is a headcount reduction in non core activities;
• Through business transactions such as mergers or acquisitions.

When companies or trustees are reviewing the administration of their pension schemes, it is the practicalities and resources required that will necessitate how and by whom the administration is done. Considering the advantages and disadvantages outlined above, when it comes to the bald question as to whether it is more cost effective to operate in-house or outsource administration, the answer is still not clear-cut.

It all comes down to the efficiency of the processes and systems in place, rather than whether the administration is in-house or outsourced, according to McQuade.

He says: “In some cases, in-house teams can be very cost effective and if the overhead costs are not fully recharged to the scheme, it can be more cost effective to be in-house. However, if you are looking for leading-edge technology, processes and service delivery, then the economies of scale that can normally be offered by outsourced providers can help them to become more cost effective.”

It is important not to focus on cost, and if an employer simply wants to save costs and achieve outsourcing as quickly as possible, n Khanna’s view, the likelihood of success is low.

He says: “If outsourcing is seen as a way to improve services to scheme members, successful implementation is more likely.”

In addition, how costs are charged can make a real difference depending on whether the scheme is administered in-house or out-house. As Reynolds points out, there can be many items not accounted for when looking at in-house costs versus outsourced costs (such as postage and disbursements costs), which are often ‘lost’ and therefore not accounted for in in-house organisations, but are often re-charged through third party contracts and premises and costs of overheads (such as heating and lighting).

For many, technology is the key culprit for eating into costs. Advances in technology may make pensions administration ultimately more cost effective and streamlined but such advances need high initial and ongoing investment.

Wickenden says: “TPAs are more likely to have the resources to be able to make advances in service, such as web access for members (which was ranked as the most desired additional functionality by in-house administered schemes).”

Money isn’t everything
When sourcing TPAs, trustees should ensure that the providers themselves have made the right investment in technology, and can provide the most efficient and effective web access for members. On the shopping list should also be other features of administration an employer or trustees should have. The TPA market is a competitive one and trustees with the right checklist in hand should be able to ensure cost efficiency through tenders from potential providers.

Mead says: “If a scheme is keen to exploit the opportunities for creative benefit structures that became available under the Finance Act 2004, they might seek to find a firm to administer their scheme that can provide these services. Also, as trustees review the contractual relationship with their in-house administrators, it is likely they will compare the service standards they receive with those available on the outsourced market. In some cases, they may not compare favourably and this may be a driver for change.”

It seems there cannot be enough emphasis on the need to almost take cost out of the decision-making process, whether assessing in-house or third party administration; if all other factors and needs are in place and met then the cost efficiencies will follow.

McQuade has a salutary warning to putting too much focus on cost. He says: “If cost saving is the primary aim of any outsourcing, the outcome is usually for the quality of the administration to be reduced, leading to increases in rework, complaints and the like, which in the end drive the costs up, not down.

“The administration should be done where it is most appropriate, taking into account the strategy of the company and trustees, so that it best delivers the service required to the scheme members. These factors vary by company and scheme, and will also depend on the views of those involved in the process.

“Outsourcing in line with strategic aims can lead to a reduction in costs if the in-house team was staffed appropriately before outsourcing and delivering a good quality service. However, if the team was understaffed in the first place and a service level agreement is going to be put in place for the first time, the costs may increase in the short term, especially when taking the implementation fee into account.”



It is quite easy to forget the actual delivery of the pension scheme proposition in the balancing up of cost efficiencies, staffing of in-house administration departments and investment in technology.

For pensions schemes to be successful they have to be marketed in the right way for the end user – the member. For employers, having control over how the scheme is packaged and presented is an important consideration. And as Hymans Robertson pensions administration and practice manager Brendan Mooney says, this will also affect the decision for an employer whether to run its own scheme or get a third party to do it.

He says: “The issues about whether a scheme should run its pensions administration in-house or not are more driven by things like the employer’s attitude to their support functions. If the employer does tend to outsource payroll, HR and flex benefits, they are more likely to outsource their pensions administration.

“The advantage of having the pensions admin run in-house is the direct control the employer or sponsoring company has over how it operates. That direct control impacts everything: from how well they want to resource it, what systems or technology they want to employ, to whether they want to be very advanced with their technology or are happy to run on a more low level.

“It also gives them control over how they brand that product. They can ensure quality and are not beholden to a third party who will have other constraints and other client demands that may or may not affect their resources and the quality provided.”

Communication is key to get members subscribed to and happy with any pension scheme on offer to them. And communication is also key to the success of any outsourced pension administration. Halliwells’s head of pensions Graham Chrystie believes it is not uncommon to find considerable dissatisfaction with outsourcing.

He says: “The usual reason seems to be that the employers and trustees do not focus themselves on what the administrator is doing. What tends to happen is they give the administrator a remit, pay them whatever it costs, and really don’t focus themselves on what the administrator is doing.

“I almost say that in defence of the administrator. But outside administrators don’t tend to communicate with the employer very well.”

There is a lesson here, of course, for both the employer or scheme administrator to ensure they are communicating with each other. Outsourcing may well be the best route for a scheme but doing so should not be seen as washing one’s hands of the exercise. Regardless of all the deliberations over how to administer a pension scheme, the issue comes down to one thing.

As Chrystie says: “My experience is that employers will pay more if they get the right service. It is not about the cheapest; the cheapest may be a very bad idea. Service is crucial.”