DC pension investments: whose risk?

Jonathan Goodwin

Much has been – and will continue to be – written about poor investment performance in money purchase (defined contribution/DC) pension schemes. In this context I am referring to poor performance relative to a benchmark rather than crashes in financial markets at large for which only politicians can fairly be blamed.

So who bears the legal responsibility for sub-standard performance – the scheme member?  Trustees? The employer? The professionals such as the investment adviser or manager?

In deciding to offer a DC scheme – rather than DB – employers believe they are transferring the investment risk to their employees – who become individually responsible for their own ‘pots’.

There is no doubt that it’s the member who bears the risk where the scheme is set up on a contractual basis, barring perhaps serious misrepresentation or impropriety on the part of those handling the investment.  Contractual schemes involve a direct contract between the employee and the insurer – sometimes arranged by the employer, as would be the case with a group personal pension plan. 

With a trust based scheme the legal position is widely treated as being the same. It isn’t. With the increasing reliance of the UK workforce on DC arrangements and a gradual realisation that the amounts saved in them are not going to meet expected living standards in retirement, I think it’s only a matter of time before we see this being challenged.

Looking at it from a purely legal point of view, it’s the scheme’s trustees who are most exposed – though employers may end up having to meet the bill, for example where they have given the trustees an indemnity.

Both trust law and pension legislation (the Pensions Act 1995) make the trustees responsible for investments. So how do we get from that to the view that it’s members who bear the risk? The short answer is that members don’t bear the whole risk – and there’s even an argument that, if scheme practice and documentation are inadequate, they don’t bear any.

There’s no doubt that it’s the trustees who are responsible for choosing the investment funds which are offered to members – and for monitoring their performance and removing a fund if expected future performance is sub-standard. An issue I had to advise on recently is the extent to which, as part of the trustees’ duty to monitor performance, they need to keep the members informed on developments which could materially affect a fund’s performance. The fund in question was overweight in a particular category of investments which the investment advisers said was a bad place to be at the time.

Typically trustees don’t pass this sort of information on to members but sit on it pending discussion at the next quarterly trustee meeting on whether to drop a fund. The problem is that the trustee decision-making process is usually slow relative to the speed at which investment outlooks change. With today’s technology, it should be easy for trustees to communicate information they have received warning them of a material development in a fund. If they don’t do that and a member, unaware of the risk, suffers a loss by continuing to invest in the fund, it isn’t hard to see how a claim could be made for breach of trust and/or statutory duty.

If members are to bear the investment risk they need to have up-to-date investment information. In the past there would have been some defence that it was impracticable to expect trustees to issue a member communication every time they received this sort of information. But today, with pension scheme websites and intranets being the norm, this sort of excuse would seem weak.

Apart from feeding investment information, is there any other way in which schemes can pass risk to members? The starting point is the investment ‘duty of care’ in the legislation – section 33 of the Pensions Act 1995. This invalidates any attempt to exclude or restrict the duty to ‘take care or exercise skill in the performance of any investment function, where the function is exercisable’ by the trustees or their delegates. The point is that, if the scheme’s investment function is positioned with the member rather than the trustees, then the trustees should be able to avoid liability. The argument is that, by giving the member the total freedom to choose between the funds offered by the trustees, this choice is removed from the trustees’ investment function. So, if a member chooses a fund which is inappropriate for his circumstances (perhaps a volatile equity fund close to retirement) then that is at his risk. Scheme documentation needs to be clear on this. The strength of a claim could turn on the precise documentation used.

But, however strong the words used, there remains the underlying duty on the trustees to select the funds to be offered and monitor them properly. The extent to which the duty includes keeping members up to date on key information is likely to come increasingly under the spotlight – a fertile ground for future complaints and litigation no doubt..

Jonathan Goodwin is a consultant at Allen & Overy LLP

Comments published on Pensions Talk do not necessarily reflect the views of Allen & Overy or its clients.

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