DC Trustees under attack?

14.07.09

 

This article was written by Vivien Cockerill, head of pensions strategy in Wragge & Co LLP's Pensions team and published in the July issue of Professional Pensions.

Most active members of occupational pension arrangements are building up benefits on a defined contribution (DC) basis. This year's purple book shows that there are 2.5 million people in occupational DC schemes and 38% of them are in defined benefit schemes with a defined contribution section. As the likes of Barclays and BP close their final salary schemes and the 'age of austerity' continues to take hold with widespread pay freezes and annual benefit statements typically showing falls in fund values of over 25% this year, it seems likely that members disenchanted with the return on their savings will increasingly attempt to challenge their trustees' management of DC investments. Complaining is cheap and relatively easy for members, but defending claims can be time consuming and expensive for trustees.

This article looks at the issues surrounding an attack on DC trustees. In particular it considers the possibility of a challenge to the default investment fund which is at the centre of most defined contribution schemes.

In times gone by, under the defined benefit approach, investment returns were often seen by members as a secondary issue. The guaranteed pension was the member's focus and whether the investment return achieved was sufficient to support the promised benefits, and whether the actuary had correctly identified the cost of providing those benefits, were concerns for the employer not the member.

As employers move away from accepting investment risk and funding risk the member is exposed to huge uncertainty. In theory the member should himself be monitoring whether his own and his employer's contributions, and the investment return they generate, will be sufficient to provide the pension he will need at retirement (taking into account annuity rates of course, which are outside the scope of this article). Of course in practice this does not happen. Despite the best efforts of trustees and employers to encourage members to engage with their schemes and to offer members a range of suitable investments, 80-90% of members consistently end up in the default fund.

As defined contribution increasingly becomes the norm, fund performance will be increasingly taking the limelight. In the short-term this means that defined contribution trustees need to communicate more regularly and simply with members about performance and the reasons for underperformance. In the medium to longer-term, as the population of defined contribution members gets older and draws closer to retirement, does it also mean that trustees' selection of and performance monitoring of their defined contribution funds is more likely to be challenged?

Currently there are very few Ombudsman or High Court challenges relating to defined contribution investment choices or default funds. Most challenges relate to administrative issues such as delay in giving effect to changes in investment strategy, or mistakes in records. Though this is perhaps surprising, it is not inexplicable. Possible reasons for the absence of challenges on investment issues might include:

• those using the default fund are likely to be less financially educated than those members who made a positive choice to invest in a particular fund
• even where members are dissatisfied there is likely to be a high level of complexity involved in proving loss;
• as DC plans are still relatively immature, there have not yet been significant numbers of retirements.

This is not to say that trustees can afford to take their eyes off the ball and accept poor performance on the basis that they are unlikely to ever face a challenge from a member. They must still comply with the investment duties that are placed on them, by statute and case law. These in summary are:

• taking such care as an ordinary prudent person would take if he invested "for the benefit of other people for whom he felt morally bound to provide
• investing in the best financial interests of members and beneficiaries
• ensuring the security, quality, liquidity and profitability of the portfolio as a whole
• diversifying the selection of investments appropriately to manage risk
• taking advice from a suitable and competent person on investment matters^[1].

The Myners Principles reviewed and effectively extended trustees duties on investments. It is sometimes forgotten that Myners also considered DC specifically and articulated the need to give sufficient information to members where there is a choice of funds, and the need to consider members' circumstances when choosing funds and to come up with a range of options which will be suitable for most members.

One of the leading authorities in relation to the investment duties of trustees, and in particular the management of risk in a trust fund, remains Nestlé v National Westminster Bank Plc^[2]. Here the claimant had become solely entitled to the residue of her grandfather's estate and claimed that the defendant trustee had mismanaged the trust for 64 years. Intriguingly, Staughton LJ rejected the bank's expert evidence, where it compared the investment of the trust with that of pension funds. He did this on the basis that pension schemes' could be expected to follow a policy of considerable caution in order to ensure that, come what may, their minimum obligations in monetary terms were fulfilled'. Clearly these comments were set in the context of the DB model, which dominated the pension's landscape at the time. Indeed, it is arguable that with today's DC culture, comparisons can be more fairly made with the private trust model. Hoffman J sitting in the High Court had acknowledged that the investment standard of the prudent man is 'extremely flexible'. He felt that a trust's investment policy should be "capable of adaptation to current economic conditions and contemporary understanding of markets and investments". He went on to say that "investments which were imprudent in the days of the gold standard may be sound and sensible in times of high inflation". Further "modern trustees acting within their investment powers are entitled to be judged by the standards of current portfolio theory, which emphasises the risk level of the entire portfolio rather than the risk attaching to each investment taken in isolation".

Some insight into how the Pensions Ombudsman is likely to deal with such issues, is offered by a case from January 2007^[3]. Here a member claimed compensation in respect of the underperformance of his AVCs in 2 with profits policies with different insurance companies. The Ombudsman rejected a claim that the booklet amounted to a misrepresentation because it did not fully explain the operation of the with profits policies, holding that the booklet was only intended to be a brief guide to the options available to members, rather than a definitive statement of how the contract would work. With regards to the collapse of Equitable Life, the Ombudsman came to the conclusion that the trustees had acted "prudently at a very difficult time". As ever, the Ombudsman made investigations and was reassured to see evidence that the trustees had sought advice from both investment and legal advisors and had also communicated openly with the members.

A question many trustees worry about in quiet moments is whether there will be future challenges relating to the default fund, and will those challenges be more likely to succeed. Often at best an individual will merely skim read the literature relating to their new pension scheme and having done this they are likely to take the least onerous course of action when completing the requisite paperwork. Certainly there does not seem to be much of an informed decision.

Could trustees successfully argue the member was fully aware of how the default fund would work? Or could a member successfully plead he did not understand what he was agreeing to and e.g. that the trustees choice of default fund was not suitable for him? It is self evident that if trustees know most members will end up in the default fund, they must pay particular attention to the composition of that fund. Will their selection of the default fund and their monitoring of its performance and continued suitability stand up to scrutiny?

Lifestyling, which is typically part of the default fund offering, brings in a raft of additional complications. For instance, was the timing right? Were the communications clear enough? And of course was there sufficient flexibility for individual member's circumstances? These are not just investment design questions, they are key to understanding how the trustees may be judged if a member complains.

There is some hope of practical guidance on the horizon currently for trustees in the form of the PADA consultation on investments, which is seeking, among other things, to identify the correct investment approach for the default fund for Personal Accounts, which are expected to have over 8 million members who are mainly low earners with a low appetite for risk and little financial education. For the first time there is going to be a full open debate about default funds. Many trustees will be following this development with interest and testing their default options against its conclusions. It is hoped they will also be contributing their experience and concerns to the debate.

Footnotes

[1] See the Pensions Act 1995 and the Investment Regulations
[2] Court of Appeal [1993] 1 W.L.R. 1260; [1994] 1 All E.R. 118 (for the High Court decision see [2002] 01 PBLR)
[3] Platts (N00496)

For further information about this published aticle, contact Kathryn Hobbs on +44 (0)121 213 2397, Amie Ryalls on +44 (0)121 213 2360 or Rebecca Davies on +44 (0)121 213 2396

This published article may contain information of general interest about current legal issues, but does not give legal advice.