How secure are your DC assets?

19 February 2015

In this alert we provide a guide for trustees embarking on a review of the security of their DC assets.

Security of Defined Contribution (DC) Assets

Most DC schemes have reviewed their arrangements in the light of The Regulator's Code of Practice No. 13 "Governance and administration of occupational defined contribution trust-based pension schemes". Generally the Code is relatively straightforward to follow. But the Code states that "Trustees must give due consideration to asset protection and understand what would happen in the event of a problem". This is a legal question which does not necessarily have a simple answer.

In order to comply with the Code and as a matter of general good governance, trustees should be looking properly at the contractual arrangements which they have in place with their DC investment provider/s. Trustees should also consider the regulatory requirements applicable to their investment provider and what would happen on insolvency. Another piece of the security jigsaw is the Financial Services Compensation Scheme.

What does the Regulator's Code of Practice say about security of DC assets?

Under the heading "Security and liquidity of scheme assets", the Code states that trustees should understand the following:

  • whether any loss might be covered by a compensation scheme or indemnity insurance;
  • the protection relating to assets held overseas;
  • the characteristics of complex investment instruments;
  • the creditworthiness of institutions which hold the scheme's investments;
  • whether investment funds offered to members are regulated; and
  • whether compensation would be available under the Financial Services Compensation Scheme.

Where do you start?

You may have investment specialists on your trustee board who can help with the questions posed by the Code. Another good starting point would be to ask your investment provider to comment on the issues set out above. However, the Regulator recognises that this is an area where trustees may need to seek independent advice.

The contract - what do the trustees actually own?

Trustees should review the contractual arrangements they have in place with their DC investment provider/s.

For some schemes, these contracts may have been in place for many years so it is general good governance for trustees to dig out their DC investment documentation and ensure that it is complete and up-to-date.

Some contracts will allow the investment provider to unilaterally amend the terms of the contract without the trustees' consent. Therefore, before undertaking any DC security review, trustees should contact their investment provider to check that the documentation which they hold is up to date and complete. Again, this is also a matter of general good governance.

Trustees should consider carefully the structure of their contractual arrangements. For example:

  • Who is their contract with? If the investment has been in place for a number of years, has the entity who the trustees originally contracted with changed e.g. because of corporate acquisition or take over?
  • What do the trustees own? For example, are the trustees entitled to notional units in a fund, shares, other assets or an insurance policy?
  • Is the trustees' investment pooled with the investments of other investors?
  • What rights under the contract do the trustees have on the default of the investment provider?
  • Has the investment provider capped the extent of its liability to the trustees?
  • What are the amendment terms i.e. can the investment provider unilaterally amend the contract without trustee consent?
  • What are the contractual termination provisions i.e. how quickly can the trustees exit the contract if they wished to do so?
  • Does the investment provider indemnify the trustees against losses caused by underlying fund managers (with whom the trustees have no direct contractual relationship)?

Trustees may be able to significantly improve the security of their DC investments by renegotiating outdated contractual terms. As a minimum, the Regulator requires you to understand the key terms of your contractual documentation.

Investment advice

Trustees should ensure that they have received written advice in relation to their DC investments from their appointed investment adviser and that this advice is re-visited from time to time.

Under section 36 of the Pensions Act 1995, before investing in any manner, trustees must obtain and consider proper advice on the question of whether the investment is satisfactory having regard to the requirements of the Occupational Pension Schemes (Investment) Regulations 2005 and to the principles contained in the Statement of Investment Principles.

In addition, trustees retaining any investment must determine at what intervals the circumstances, and in particular the nature of the investment, make it desirable to obtain investment advice as mentioned above.

What regulatory requirements is the investment provider subject to?

On 1 April 2013, the Prudential Regulation Authority (the PRA) became responsible for the prudential regulation and supervision of banks, building societies, credit unions, insurers and major investment firms.

The PRA was created by the Financial Services Act 2012 and is part of the Bank of England. The PRA works alongside the Financial Conduct Authority.

Trustees should consider what regulatory requirements are imposed on their investment provider. For example, if the trustees have a contract of insurance, there are restrictions on insurers which limit their permitted business activities to insurance business and activities arising directly from that business.

UK insurers are required by the Financial Services and Markets Act 2000 to conduct their business in a "prudent manner" and to hold "appropriate financial resources".

Is the Financial Services Compensation Scheme (FSCS) available to the trustees?

This is not a straight-forward question. Trustees could ask their investment provider to confirm its views of the FSCS position. Trustees can also contact the FSCS direct.

The general rule is that pension and retirement funds (and the trustees) of large companies cannot claim from the FSCS.

A "large company" is a company that is not a small company and a small company is one which satisfies two or more of the following conditions:

  • Turnover - Not more than £6.5 million
  • Balance sheet total - Not more than £3.26 million
  • Number of employees - Not more than 50

However, there is an exemption which provides that the trustees can be eligible FSCS claimants for the purposes of long term insurance (through which products such as annuities are written).

Could trustees improve the security of their investment?

If trustees have concerns about the security of their DC investment, before deciding to move their investments altogether, trustees should ask their investment provider to re-consider the contractual terms. Whether this is viable depends on the nature of the investment. There is often less scope to re-negotiate the terms of pooled funds and insurance contracts when compared to bespoke investment management agreements. If you can renegotiate, points to consider include:

  • The removal of contractual terms which seek to limit the investment providers' liability.
  • Asking for reporting to the trustees to be more frequent or in greater detail.
  • Asking for contractual commitments to ring-fence the trustees' assets from those of other investors.
  • Asking for the contractual agreement to indemnify against any losses caused by third party fund managers (with whom the trustees have no contractual relationship).

The level of new terms which can be negotiated depends on the trustees' negotiating power. It is important to be realistic about the extent to which changes in terms can be achieved when compared to the terms and costs of moving to a new mandate.

What should trustees be saying to members?

The Code recommends that trustees should communicate with members on the following:

  • Whether the investment funds are regulated, for example by the Financial Conduct Authority or a similar authority overseas.
  • Whether the investment funds qualify for protection under the FSCS.

Communications to members should be carefully worded. In particular, trustees should be cautious about making a definitive statement that the FSCS would be available. However, having conducted a security review, trustees should be in a position that they can make a clear statement on the applicable regulatory requirements and the contractual position. This should give members some comfort.


NOT LEGAL ADVICE. Information made available on this website in any form is for information purposes only. It is not, and should not be taken as, legal advice. You should not rely on, or take or fail to take any action based upon this information. Never disregard professional legal advice or delay in seeking legal advice because of something you have read on this website. Gowling WLG professionals will be pleased to discuss resolutions to specific legal concerns you may have.

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