In the latest of Newton Investment Management's DC updates, Julian Lyne looks to the US for lessons in protecting DC schemes
The threat of litigation, or perhaps more realistically the perceived risk of litigation, has been a common topic of debate in the UK defined contribution (DC) market for many years. It is often raised in discussions surrounding fund choice, the closing down of funds, whether the options should be active and/or passive, and of course the 'benefit of hindsight' performance concerns. Fortunately, although there have been examples of the courts being involved in scheme disputes, some quick research highlights few UK examples. However, the same cannot be said for the US market.
From engaging with clients and consultants alike, it is clear to us that those running DC plans in North America are alive to the threat of litigation, and are quite right to be. In a discussion with a consultant about the role of an absolute-return strategy in a target-date fund, the key issue revolved around fees - not because of concerns about the ‘value for money' or indeed the appropriateness of the strategy, but because any strategy that is not offered at a passive fee is felt potentially to open the plan up to litigation.
When I researched the topic, it was clear that litigation and DC do seem to go hand in hand in the US. As one eye-catching, if rather crass, headline put it: 401(k) Litigation: The 'Next Asbestos'?. The resulting impact on plan sponsor behaviour is telling. As highlighted in the 2017 Callan DC Survey, sponsors now see reviewing fees as being far and away the single most important act for improving the fiduciary position of their DC plan.
So what does this mean? In a quantitative easing-fuelled world where markets only go up, it could be argued that it's all about fees. But in a world where that trajectory may well change, and where members are facing investment challenges that are more demanding than ever (owing to flexibility and the low-yield environment), scheme sponsors and trustees will need to offer better solutions. However, in order to 'protect' themselves from 'benefit of hindsight' litigation risk, schemes must have a bespoke governance structure, reflective of their governance resource, which captures the objective of the scheme, the investment philosophy and beliefs, and the decision-making process. By defining objectives (including the role and aims of the default strategy), and having a robust and frequent review mechanism (with external support and advice if needed), schemes can deliver a genuine 'value-add' DC arrangement rather than simply taking a ‘risk-free' approach. While fees may be the issue today, should members reach retirement and find their pots are not of a sufficient size, the whole investment proposition will come under scrutiny.
