Financial sector growth and pensions anarchy: are fiduciary duties the answer?
The latest TUC Economic Report, published today, finds that the UK economy remains unbalanced, particularly in terms of an over-reliance on the financial sector. As millions of workers are automatically enrolled into insurance-based defined contribution schemes from 2012 onwards, the City is set to receive another significant stimulus, funded by individual savers, their employers, and the government in the form of pensions tax relief.
As noted in the report,
in the year to June 2012… GDP fell by 0.8% whilst manufacturing output fell by a far steeper 3.1%. In contrast, the output of business and financial services rose by 0.8%. While without this growth the fall in GDP would have been even steeper, this trend does raise worrying questions about the shape of our future economy.
The report therefore offers a timely opportunity to reflect on the dependence of automatic enrolment – which will extend pensions provision to millions of under-pensioned workers and is therefore welcomed by the TUC – on financial services. One area of particular concern is the governance of contract-based pension schemes, or more precisely, the lack of governance in such schemes.
Essentially there are two types of workplace pension scheme: trust-based and contract-based. Trust-based schemes are governed by a board of trustees whose primary task is to protect the benefits of pension scheme members (although this of course involves a wide and complex range of functions). Legally speaking, only trust-based schemes qualify as ‘occupational’ pensions, which is why the unfortunate term ‘workplace pensions’ has entered the pensions lexicon of late. Contract-based schemes generally have no formal scheme-level governance, but involve merely a contract of service between member and provider, usually an insurance company. Where employers adopt a contract-based product for a portion of their workforce, this single product is known as a ‘group personal pension’ but the primary relationship remains between individual and provider.
All defined benefit schemes must be trust-based, but defined contribution schemes can be either trust-based or contract-based. It is not implausible to suggest that contract-based defined contribution pensions are so far removed from the traditional image of what a pension is, that they are not pensions at all, but rather long-term savings accounts with certain tax advantages.
Furthermore, in their report Whose Duty? campaign group FairPensions make the persuasive argument that contract-based pensions are ‘fundamentally at odds with the mechanics of auto-enrolment’. The absence of trustees means that ‘the saver is assumed to be an active consumer making informed decisions in a well-functioning market’, but in a complex investment chain involving employers, advisers, insurance companies and (internal and external) asset managers, ‘the saver is the only person in this chain who exercises virtually no influence over any key decisions’.
The solution offered by FairPensions is that fiduciary duties should apply to everybody involved in looking after pension scheme members’ savings in a contract-based scheme. Given that different actors in the investment chain may have misaligned interests – from each other as well as from the ultimate beneficiary – it is necessary to establish fiduciary relationships to ensure that pension scheme members’ interests are always put first.
(Obviously it is quite bizarre that such a duty does not already exist, but this is the brave new world of automatic enrolment – by necessity, it will be many years before the UK’s post-Turner approach to pensions provision is completely settled.)
This would be a hugely important step forward, yet it is worth noting fears that fiduciary duties could be interpreted narrowly as a duty to deliver returns to scheme members. In practice, pension savers could be best served by those who control their money considering a wider range of factors when choosing investments, not simply short-term returns. In trust-based provision, for instance, pension scheme trustees generally have responsibilities that go beyond fiduciary duties when exercising their duty to protect member benefits – and they have more freedom in how they achieve their objectives. However, as FairPensions point out in an earlier report, this interpretation of fiduciary duties is far too narrow. There is nothing in the concept of fiduciary relationships that prevents the unique nature of automatically enrolled pension investors being recognised.
Alas, even with a wider interpretation of fiduciary duties, they will not provide a panacea for the governance problems inherent in contract-based pensions. As such, the Kay Review of UK Equity Markets and Long-Term Decision Making, despite advocating fiduciary duties, insisted that ‘the establishment of market structures which provide appropriate incentives’, rather than simply ‘attempt[ing] to control behaviour in the face of inappropriate commercial incentives’ should be the over-riding policy objective. Translated into pensions policy, this means that the business model of contract-based pensions, not only how they are governed, may be flawed and ultimately unsustainable.
It is possible that contract-based pension scheme can be governed more effectively, even in the absence of formal trustees and fiduciary duties in the investment chain. Many employers with group personal pension schemes have established ‘management committees’. These committees can serve as useful sources of information and a degree of representation for scheme members. However, they have no formal oversight duties, and owe their existence to the discretion of employers. And there is very little guidance on how to organise a committee from the Department for Work and Pensions or the Pensions Regulator.
Additionally, because committees are workplace-based rather than scheme-based, only the interests of active members are considered. The interests of deferred members (who as a rule will retain their workplace pension as a personal pension when they move to a new employer and leave the group product) remain in scope for trustees in trust-based schemes, but not management committees in contract-based schemes.
Given that contract-based pension schemes also fall victim to the discrepancies in the regulation by government of defined contribution schemes – as pointed out by the National Audit Office – this anarchic approach to scheme governance must be urgently addressed. As the financial sector begins to benefit from a further boost towards the end of this year, it must surely accept a greater range of application for fiduciary duties in relation to pensions.