IPL - Vol 80 - Philip Bennett Susan P Serota B Bethune A Whiston

Volume 80 – May 2014

9

Workshop 4

Outline of Topics Discussed During the Workshop on the Risks of Implementing

a DC Plan

Philip Bennett

Susan P. Serota

B. Bethune A. Whiston

Philip Bennett

Partner

Slaughter and May London, United Kingdom

[email protected]

Susan P. Serota,

Partner

Pillsbury Winthrop Shaw Pittman New York, USA

[email protected]

B. Bethune A. Whiston

Partner

Morneau Shepell Toronto, Canada

[email protected]

The driving force in many jurisdictions behind the shift in the private sector to DC plans has been the perception that DB plans present employers with greater funding risk. What many employers continue to ignore, however, is that while it may be true that DC plans have lower funding risk, they present an employer with greater legal risk, due to the potential legal duties owed to DC plan participants in the areas of contributions, investment of plan assets, fees charged, conversions from DB plans and communications. The DC Risks Workshop held during the IPEBLA Rome Conference provided a high level overview of the legal framework and administration of DC plans in Canada, the United States and the United Kingdom and in particular the common areas of risk related to these types of plans.

This article reflects the law as at 20 May 2013

Introduction

The Workshop was very well attended, with

approximately fifty people from the

following 12 jurisdictions: Belgium, Brazil,

Canada, Germany, Ireland, Jamaica, the

Netherlands, Portugal, South Africa,

Sweden, the United Kingdom and the

United States.

Some context for the discussion was

provided by describing some of the

differences in terminology used around

defined contribution or money purchase

plans in the different jurisdictions. The

fiduciary responsibilities of the different

stakeholders were described along with the

iffering ro e of the “tr tee” in Cana a

the United States and the United Kingdom.

An outline for the Workshop was distributed

to the participants at the conference which

(a) set out in some detail the rules in place

as at May 2013, in each jurisdiction under

discussion, whether legislative, best

practice or based in common law in a

number of relevant areas, and (b) included

a sample structure of a typical DC plan in

each of the three jurisdictions. A copy of

that outline is set out below.

mailto:[email protected]



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Position in Canada1 Position in USA Position in the UK

A. Typical DC Plan structure in legal terms2

1.1 Employer (Board of Directors) establishes DC plan.

1.2 Typically, in Canada, the primary fiduciary role lies with the p an “A mini trator” in accordance with the pension standards legislation of the particular jurisdiction. In the common law jurisdictions there are several choices as to who can be the Administrator. In most cases, the Administrator is the employer through its Board of Directors. In Quebec and Manitoba, for a typical plan, it must be the Pension Committee.

1.3 The Administrator has a fiduciary or a fiduciary-like duty. However, two of 11 jurisdictions also specify that the Administrator is a trustee for the employer, members and others with an interest in the plan.

1.4 Board resolutions or plan document will contemplate agreement with “tr tee”/f n ing agent an specify who will act as “A mini trator” of the p an. If the Administrator is the employer, the Board of Directors will typically delegate responsibility for administration of the plan and the fund to a Pension Committee. The Board legally retains a fiduciary obligation to monitor the Committee. Committee is also a fiduciary and typically

1.1 Employer establishes DC plan by Board of Directors adopting plan and authorizing trust agreement with bank or trust company, alternatively with an insurance company.

1.2 Board resolutions or plan document will authorise named fiduciaries for plan, including trustee and committee(s) for administration and investment of plan assets.

1.3 Recordkeeping can be done internally or with a third party record keeper.

1.4 Trust Agreement can provide trustee with discretion to select investments or, if no discretion, where the trustee is a “ irecte ” tr tee subject to investment manager instructions, committee instructions or participant instructions.

1.5 Employer reserves under plan document, right to amend or terminate plan, change contribution formula, cease contributions, or change trustee.

1.6 Plan committee can be comprised internally of company officers, although certain collectively bargained plans often have both employer and union representation on plan board.

1.7 ERISA Part 4 of Title I sets forth rules for fiduciaries of plans, including duty to act solely in interest of

1.1 Employer establishes DC plan by entering into Trust Deed with plan trustee (usually wholly owned subsidiary of sponsoring employer whose sole purpose is to act as DC plan trustee).

Note: In this outline,

references to a DC Plan for the UK are to an “occ pationa pen ion cheme” which provi e money purchase benefits. An occupational pension scheme is established in the UK by an employer. It is not to be confused with a personal pension scheme (or a so ca e “gro p” per ona pension scheme – just, in law, a personal pension scheme) established by an insurance company or other financial services provider. Personal pension schemes are outside the scope of this outline.

1.2 Trust Deed, in general, will set out all powers relating to holding of the trust assets, management of trust assets and keeping of retirement accounts for beneficiaries to trustee.

1.3 Trust Deed will usually give trustee powers to delegate:

(a) custody functions to a third party custodian, and

(b) retirement account record keeping function to a third party administrator.

1.4 Trust Deed will usually confer on trustee power to select a range of pooled investment vehicles in which plan members may direct that their

1 In Canada, pension standards legislation is adopted separately by the 10 provinces and the Federal

jurisdiction. There is also federal tax legislation in place respecting pensions. Each jurisdiction has different rules, and the Province of Quebec, being a civil law province, has significantly different rules. The highest number of pension plans is registered in the Province of Ontario, therefore, unless otherwise indicated, this chart specifies the rules in place in Ontario.

2 See Diagrams A1, A2 and A3 (attached) for typical structure showing legal relationships in Canada,

the USA and the UK.

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is responsible to monitor all agents or service providers, including the funding agent.

1.5 The Pension Committee is often comprised internally of company officers, although there is a move in Canada to encourage jointly sponsored and governed pension plans and independent committee members.

1.6 All employees of the company who help administer the plan and all “agent ” of the p an “A mini trator” are also held to a fiduciary standard of care.

1.7 Recordkeeping can be done internally or with a third party record keeper.

1.8 Employer reserves under plan document, right to amend or terminate plan.

participants and beneficiaries, prudent man standards, diversification of investments and the need to follow plan documents. ERISA also authorizes appointment of investment managers, delegation of fiduciary duties, personal liability for breach of fiduciary duties, prohibited transactions and statutory exemptions.

1.1 Potential criminal liability for failure to make required reportings and disclosures under ERISA. Other laws deal with fraud, etc.

retirement account balances may be invested by giving notice to that effect to the tr tee or the tr tee’ agent.

1.5 Employer reserves, under Trust Deed, right to terminate employer contribution or to reduce employer contributions or to wind-up plan. The employer will also reserve, under Trust Deed, the power to amend the plan (but, benefits derived from contributions up to the date the power of amendment is exercised will be protected (Section 67 of the UK Pensions Act 1995)). Exercise of power of amendment may also require trustee consent (depends on the terms on which the Trust Deed has been drafted).

1.6 Trustee company is, in most circumstances, required to ensure that at least

1/3

rd of the

board of directors of the trustee company are “member nominate irector ” n er Section 242 of the UK Pensions Act 2004.

1.7 Section 34 of the UK Pensions Act 1995 says that tr tee’ inve tment power may only be delegated to, in general, those authorised to undertake investment functions under UK Financial Services and Markets Act 2000.

1.8 It is a criminal offence for a trustee to take a day to day investment decision in relation to investments regulated by Financial Services and Markets Act 2000 unless the trustee falls within a safe harbour.

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B. Terminology: Divided by a common language

Topic: 1. Trustee

1.1 In Ontario, the Pension Benefits Act specifies that the “A mini trator” ha a duty to exercise the care, diligence and skill that a person of ordinary prudence would exercise in dealing with the property of another person, with the relevant knowledge and skill the person possesses or ought to possess.

1.2 Where it is reasonable and prudent the Administrator may employ one of more agents in the administration of the plan and the administration and investment of the fund.

1.3 No person other than a prescribed person may be a trustee of the pension fund.

1.4 The pension fund may be administered only by certain entities, including most commonly, an insurance company, or a trust in Canada governed by a written trust agreement with a trust company or three or more individuals.

1.5 The trust/custodial agreement typically provides for funding agent to take directions on investments from participants, investment manager or Pension Committee.

1.6 Please refer to Canadian Association of Pension Supervisory Authorities Guideline #5 on Fund Holder Arrangements in the various jurisdictions for further information.

1.1 Trustee holds plan assets and may have discretion over investment or may be a “ irecte tr tee” ( ee A.1.4)—sometimes referred

to a a “c to ian”. Whether trustee/custodian has discretion over investment will determine its status as an ERISA fiduciary.

1.2 Trustee must be a bank, trust company or individuals, depending on state law. Tax Code also permits plan assets to be held by an insurance company, e.g. in a deposit contract, annuity contract or separate account.

1.3 Plan administrator is a designation under the plan document required by ERISA. If no person or entity appointed as plan administrator, the employer is deemed to be the plan administrator. ERISA sets forth specific duties for the plan administrator, including making certain reports to the Department of Labor and certain disclosures to participants.

1.4 Plan document can provide for one or more committees with specific functions, i.e. plan administration, investment authority (appointment of investment managers), and review of participant claims and appeals.

1.5 Master trusts are typically trusts that cover more than one plan of an employer(s) all of whom are in the same controlled group (see B.2.1)

permitting aggregate investment of various plan ’ assets.

1.6 Group trusts are investment vehicles used by specific investment managers which are offered to unrelated plans and which are treated as a sub-tr t of the p an’ tr t. Similarly an insurance

1.1 As a general rule, all of the fiduciary functions for the DC plan established under trust are vested in the trustee of the DC plan with power to delegate.

1.2 The trustee of the DC plan is usually a wholly owned subsidiary of the sponsoring employer whose sole purpose is to act as trustee of the DC plan which acts through its board of directors.

1.3 The board of directors is, in general, sheltered by the corporate veil and an individual director is not, in general, considered as a trustee. In other words the duties and liabilities of the trustee company will derive from company law not trust law.

1.4 However, the wholly owned subsidiary company, when acting as trustee, will be subject to the usual trust law duties and liabilities (subject to the extent these may be modified by the terms of the Trust Deed or by overriding legislation).

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company separate account can be used for a single plan’ inve tment or a an investment vehicle available to more than one plan. Both group trusts and separate accounts must be limited to investors which are tax qualified retirement plans, IRAs and government pension plans.

1.7 Collective trusts are a type of group trust sponsored by a bank for investment of assets of more than one plan.

Topic: 2. Multi-employer plans/ singular employer plans/ control group employer plans

2.1 When someone refers to a single employer pension plan in Canada, this can include a plan with more than one participating employer, but where all participating employers are part of a related group of companies.

2.2 Except to the extent that a related company participates in the plan, there is generally no concept of “contro gro p iabi it ” in Cana a.

2.3 Definitions of a multi-employer plan differ between the Canadian jurisdictions and also under the Income Tax Act. Recent changes to pension standards legislation in many of the provinces have also introduced new plan designs. Please refer to the Summary of Pension Legislation Charts related to Multi-Employer and Shared Risk Plans.

2.1 US Internal Revenue Code (IRC) and ERISA establish concept of controlled group of companies, typically an 80% ownership group. All members of the controlled group regardless of whether their employees are covered by the plan, are subject to joint and several liability for minimum funding requirements and termination liability of DB plans, withdrawal liability from a multi-employer plan and certain excise taxes.

2.2 A multi-employer plan is a plan which is covered by one or more a collective bargaining agreement to which unrelated employers (not members of the same controlled group) contribute. These plans are usually subject to special labor law rules, i.e Taft Hartley plans.

2.3 A number of DC plans are available through a master or prototype plan offered by a mutual fund family, insurance company, trade group, etc. This permits the same plan document to be used for more than one employer.

2.1 Prior to 6th April, 2006, tax legislation meant that, if a DC plan had more than one employer participating in a plan, the other employers would, in broad terms, all have to be in the same corporate group as the “principa emp o er” an the Trust Deed would have to make provision for a participating employer and its employees to cease to be eligible to contribute to the DC plan if that participating employer left the principal employer’ gro p.

2.2 From 6th April, 2006 the tax requirement for employers to be in the same group in a plan with 2 or more participating employers was abolished.

2.3 However, where the plan is set up by a company for its own employees then, in general, it will arrange for the Trust Deed to contain similar provisions to those required for tax purposes prior to 6th April, 2006 so that if a participating employer ceased to be in the same group as the principal employer, then it would have to cease to participate.

2.4 However, there are now DC p an (“Master Trusts”)

established by insurance companies and other financial product providers where there is no requirement that the employers who participate should be in the same group

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as the insurance company or other financial services provider establishing the Master Trust. In the case of a Master Trust, the trustee would usually be an independent trustee company (whose business is to act, for a fee, as the trustee of occupational pension schemes).

C. Legal duties (and associated legal risks) owed to Plan members in connection with (i) conversion of past service DB benefits into DC benefits, and (b) retaining past service DB

benefits but moving to future service DC benefits

1. Decision to convert DB plan is a plan sponsor/employer decision (subject to collective bargaining requirements, if applicable). The decision is not subject to fiduciary duties.

2. In most jurisdictions there is little guidance in the legislation respecting the rules related to conversions. In Ontario and several of the other jurisdictions, the regulators have developed policies respecting how a plan sponsor may convert a registered pension plan.

3. It is not permissible in about half of the jurisdictions to require a plan member to convert their past service from a defined benefit to a money purchase or defined contribution benefit (these terms can be used interchangeably in Canada – DC is most common). The other jurisdictions will allow it but there are usually conditions attached.

4. In many jurisdictions salary projection will be required if the plan requires it, and ancillary benefits must be accounted for.

5. Generally speaking, when a plan is converted for future service, the plan continues to have one registration number for both the DB and DC components, and the DB component may continue even though future service may be frozen.

6. The process of conversion requires a lot of

1. Decision to convert DB plan is a plan sponsor/employer decision not subject to fiduciary duties..

2. Conversion of DB plan to a DC plan is treated as a termination of the DB plan and requires vesting of all accrued benefits under DB plan. Future service can be covered under a DC plan. Special notice with detailed disclosure is required to be given to participants prior to conversion.

3. Need to consider age discrimination law implications.

4. Money purchase plans and profit sharing plans, e.g. 401(k) plans, are defined contribution plans having individual accounts for each participant and beneficiary. Contributions to a money purchase plan (a) cannot be discretionary and cannot be limited by profits of the employer (s) and (b) are subject to the Code and ERISA minimum funding requirements. Also a money purchase plan must provide a qualified joint and survivor as the normal form of benefit under the plan.

1. The effect of Section 67 of the UK Pensions Act 1995 (which

protects accrued rights) is that conversion of past service defined benefit benefits into money purchase benefits is only permissible with the informed consent of the member. See, for example, HR Trustees Limited v German a

decision of the High Court on 10

th November, 2009 [2009]

EWHC 2785 (Ch) for an example where such a past service conversion exercise (which took place prior to the effective date of the protection conferred by Section 67 of the UK Pensions Act 1995 came into force, was litigated).

Note: In the UK money

purchase benefits or defined contribution benefits or DC benefits are used interchangeably (as are money purchase scheme or plan and defined contribution scheme or plan, or DC scheme or plan).

2. Past service conversions usually end up being structured a what are ca e “enhance tran fer va e exerci e ” where the member is given the opportunity to transfer his defined benefit benefits to a new money purchase plan (usually a personal pension plan provided by an insurance company in return for an enhancement in his statutory transfer value (or a cash inducement) (or both)).

3. The ability to change defined benefit plan benefits for future service into money purchase

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communication with plan members and this increases the chance for misstatements and misunderstandings.

7. Litigation may be brought over conversions. Historically, this has occurred after plan members have retired and seen the impact that the conversion has had on their benefits. The lapse of time makes it difficult for an employer to defend itself as it will need to locate old records and witnesses may no longer be available. To date, limitations statutes have been of very limited help in countering these claims.

8. There may be an open-ended potential for liability owing to future changes in regulatory practices and case law. For example, in a 2010 case out of Alberta, the regulator undid a plan amendment that froze earnings levels under the closed DB provision of a converted plan, despite having registered the amendment three years earlier.

benefits for future service is a f nction of the p an’ power of amendment (coupled with any reserved right to the employer under the plan to terminate, without winding-up the plan, the future service accrual of defined benefit benefits in the plan).

Comment: For a case where

the power of amendment prevented the change to the p an’ efine benefit benefit for future service, see Lloyds Bank Pension Trust Corporation Ltd v Lloyds Bank Plc [1996] Pens. L.R. 263.

4. Where the p an’ power of amendment is adequate to allow the change, it is still necessary to check employment contracts to see whether the employment contract has committed the employer to provide a defined benefit benefit and, accordingly, has restricted the emp o er’ abi it to exerci e any reserved power of amendment of the plan.

5. However, the fallback position is to go through the process of terminating, on due notice and after consultation, the employment contracts of the employees, coupled with an offer of re-employment on identical terms, except as to pension benefits, once the contractual notice period has expired.

Note 1: It is necessary to

proceed with care, as employees have rights under the UK Employment Rights Act 1996 not to be “ nfair i mi e ” an o an appropriate due process needs to be followed.

Note 2: The fact that the

employer may go down this route can be a useful way of persuading a plan trustee to agree to exercise the power of amendment to allow future service benefits to be changed from defined benefit to money purchase (in a plan where the power of amendment is a joint power held by the employer

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and the trustee) – but without the employer breaching the implied duty of mutual trust and confidence.

6. If the future service contribution rate for the defined contribution plan is age-related, then it is necessary to establish whether age-related contributions would infringe age discrimination legislation. See, for example, the A vocate Genera ’ opinion issued on 7

th February, 2013 in

relation to Kristensen v Experian A/S [C-476/11], which said that age-related contributions could be permissible. A decision of the ECJ in this case is awaited (as at 7

th May, 2013).

D. Legal duties owed (and associated legal risks) to members and level of contributions made to the DC plan (will the resulting retirement income level satisfy the purpose of plan?)

1. In accordance with the Federal Income Tax Act, the employer must contribute at least 1% of payroll to a DC plan. Employee contributions are frequently required by the plan provisions, but not always. The plan terms may also permit employees to make optional contributions on top of the required contributions, and these may or may not be partially or wholly matched.

2. The Income Tax Act restricts the amount that may be contributed to a DC registered pension plan for an individual. In 2013, the limit is the lesser of 18% of compensation and $24,270.

3. It is permissible to have different contribution rates for different classes of employees. If contributions are linked to age, plan sponsors are often careful to also incorporate another component, like service, into the formula to avoid human rights issues.

4. Typically, in Canada, DC plans contemplate total contributions of somewhere between 4% and 12% of compensation, whereas estimates of what is an appropriate rate range between 10% and 20% of

1. 401(k) plans and most other DC plans are not subject to minimum funding or contribution rules. (Money purchase plans are treated differently.) See C.4.

2. Pre-tax, after-tax and employer matching contributions are subject to testing to assure no discrimination in favour of highly compensated employees. Safe harbour testing arrangement available for certain 401(k) plans, as well as automatic enrolment features.

1. UK “a to-enro ment” legislation, which is in the course of coming into force over a transitional period, lays down, for a DC plan, minimum levels of employer and employee contributions. Employees may elect to opt-o t of ch “a to-enro ment” but, in summary, would have to be “re-enro e ” once ever 3 years.

2, So ong a the member’ money purchase benefits are directly related to the way in which the contributions of the employer and, if applicable, the member, are credited to the member’ retirement account or invested, there are no minimum funding requirements and no minimum guaranteed return requirements (and no capital protection guarantee).

Note 1: If the plan offered a

guarantee, then it would, in effect be treate a a “ efine benefit” p an for f n ing purposes and would then be within the funding regime for defined benefit plans.

Note 2: This means that any

guarantees are offered in the investment product, and if the investment product does not perform (e.g. the provider

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annual income.

5. Higher contribution rates, however, may be inappropriate for lower income workers. These workers may not benefit from the tax credit for pension plan contributions and may have their social security benefits clawed back because of their pension income.

6. There are issues with offering auto escalation for contribution rates in Canada.

becomes insolvent), then that would automatically flow through to reduce the value of the member’ retirement account.

3. Apart from provisions relating to the minimum contributions deriving from the auto-enrolment requirements (see the UK Pensions Act 2008), there is no positive legal duty on a UK employer to ensure that an employee achieves any particular level of retirement income.

4. However, it is not permissible under the Equality Act 2010

(which is the current UK legislation which contains the transition of various EU Directives on equality) to retire compulsorily an employee on attaining a specified retirement age (unless this can be objectively justified). So, there is an incentive on employers, looking to the longer term, to try to ensure that the employee has an adequate level of retirement income in order to be able to afford to retire.

5. Contribution levels need to be non-discriminatory on grounds of sex, age, etc.

6. However, there is a current safe harbour for age-related contributions where the purpose of the age-related contributions is to aim to make the retirement income generated by the contribution the same or nearly equal as between a younger employee and an older employee doing like work. See, for example, the Equality Act (Age Exceptions) Order 2010, Schedule 1, Paragraph 4.

Note: This reflects the fact

that the younger employee has a longer period of time for the contributions to be invested.

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E. Legal duties owed to plan members (and associated legal risks) in relation to investment choices offered (including number of investment options and default options and whether regard should be had to behavioural psychology/ behavioural economic theory in deciding

those choices in discharging the duty owed to the plan members)

1. There is no safe harbor yet in Canada respecting investment choices offered to DC plan members. One jurisdiction has drafted legislation that would permit a limited form of safe harbor but it is not yet in force.

2. With a few exceptions, Canadian law is principles-based (prudent person rule) rather than rules-based as regards plan investments.

3. There is some disagreement as to whether it is less risky for the plan sponsor to select the plan investments on a global basis or permit members to have a choice of a platform of investments selected by the plan sponsor.

4. Where member choice is permitted, an unlimited range of options is not recommended. Rather, the number of options may range from 8 to 12 on average.

5. Cana a’ pen ion ec ritie and insurance regulators have collectively adopted Guidelines for Capital Accumulation Plans (the CAP Guidelines), which describe recommended practices in the administration of investment options under member-directed DC plans. These Guidelines are not law, but are likely to be considered appropriate industry practice by a decision-maker.

6. There are additional obligations of the administrator under member-directed DC plans, including additional communications; the selection of an appropriate range of investment options and “ efa t f n ” an the preparation and distribution of member educational materials and decision-making tools. In contrast to a DC plan under which the administrator retains responsibility for investments,

1. Where participants can choose investment option for their accounts, ERISA provides that a plan fiduciary is not re pon ib e for participant ’ choices (404(c) plans). However, if a menu of investment funds or options are chosen by the plan fiduciary, the fiduciary is required to choose the menu under fiduciary standards.

2. 404(c) requires certain diversity of investment options to be available to participants, specific disclosure re choices and fees/expenses and disclaimer of fiduciary responsibility by plan fiduciaries.

3. Certain types of investment options (e.g. a balanced fund) may qua if a a “q a ifie efa t inve tment a ternative” (QDIA) used where the participant does not make a pro-active investment decision.

Note: Money market and

stable value funds do not qualify as a QDIA.

1. In ofar a it i the emp o er’ responsibility for the design of the investment options (or the structure of the plan documentation within which the investment options operate), it is likely that the employer will owe a duty of care to the employees, unless disclaimed.

2. That duty of care, if it can be established, would require the employer to use reasonable skill and care in relation to this aspect of the plan design.

3. However, it would be seem to follow that, if the employer, not being an investment expert, relies on the advice of an investment consultant who is, prima facie, competent, then the employer will have i charge the emp o er’ duty of care (and the claim may then be against the investment consultant).

4. There is a Pensions Ombudsman decision on 10

th

November, 1998 in Brown v Perot Systems Europe Limited, as Trustee of the Perot Systems Europe Retirement Benefit Scheme (F00785) in which it was decided that the employer had been in breach of a duty to the employee in establishing a plan which invested in insurance products where there were heavy early termination penalties, if the employee who was a plan member, ceased to have contributions paid in respect of him (e.g. on leaving employment).

5. In this case, the nature of the emp o er’ workforce wa that turnover was relatively high, and so, almost by definition, most employees would suffer an early termination penalty in respect of the insurance products in which the amounts credited to their retirement

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there are more avenues for the administrator to make mistakes or misstatements.

7. Existing case law shows that liability will flow even if mistakes or misstatements are inadvertent and innocent.

8. There is no requirement to have regard to behavioral psychology in determining what investment options to offer members, however, the CAP Guidelines recommend that the plan sponsor should ensure a range of investment options is made available taking into consideration the purpose of the CAP. The CAP Guidelines also suggest the factors a CAP sponsor should consider when choosing investment options The factors include:

(a) any default option that may be selected by the CAP sponsor;

(b) the purpose of the CAP;

(c) the number of investment options to be made available;

(d) the fees associated with the investment options;

(e) the CAP pon or’ abi it to periodically review the options;

(f) the diversity and demographics of CAP members;

(g) the degree of diversification among the investment options to be made available to members;

(h) the liquidity of the investment options; and,

(i) the level of risk associated with the investment options.

9. Plan sponsors in Canada have moved, over the last 20 years, from offering a money market default fund, to offering a balanced fund as a default and more recently to offering a target-date or life-cycle fund as a default.

accounts had been invested.

6. It is relatively rare, in the UK, for large DC plans to allow the plan member to choose how to invest the plan assets backing his retirement account amongst an unlimited range of bonds and shares listed on a recognised stock exchange.

7. Accordingly, the more usual plan design is that the member is allowed to direct the investment of the plan assets backing his retirement account from a menu.

8. The menu may, in part, be limited by the terms of the Trust Deed (i.e. an employer plan design decision – partly linked to legal risk management).

9. The trustee then has a prudent person duty, within the powers available under the terms of the Trust Deed, in selecting the pooled investment vehicles to include on the plan menu, in terms of:

(a) asset class,

(b) management style (active versus passive), and

(c) having regard to the costs of the investment vehicle in question.

10. It is an open issue as to whether the employer or the plan trustee is under a duty to take account of behavioural finance theory.

Note: The UK Financial

Conduct Authority has expressly stated that behavioural economics is a factor it considers relevant in assessing financial product design, marketing and sales processes (see Speech by Martin Wheatley, Chief Executive of the UK Financial Conduct Authority on 10

th

April, 2013) (http://www.fca.uk/news/speeches/human-face-of-regulation)

11. However, it is certainly not impossible that, in looking at the way which plan investment options have been designed and presented, the following

http://www.fca.uk/news/speeches/human-face-of-regulation

http://www.fca.uk/news/speeches/human-face-of-regulation

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findings could be made by an English court:

(a) in offering the ABC pension plan to an offer to an employee, the employer owes an implied duty to offer a pension plan that is rea onab “fit for p rpo e”.

(b) “fit for p rpo e” might embrace the following:

(i) the charging structure of the investment options under the plan,

Comment: Each £1

of future retirement income is potentially at least £1 (i.e. once adjusted for compounding the effect of charges in reducing retirement income can be significant) off future retirement income.

(ii) to offer a reasonable range of investment options,

(iii) to aim to have reasonably competent investment managers of the investment option in question (or to go down the index tracking/passive route), and

(iv) in determining the number of choices available and the way they are presented, to “n ge” emp o ee towards making better decisions (as supported by well established research in behavioural finance theory).

Comment: That said,

there are clearly causation issues to establish and link to loss alleged to be suffered.

12. The UK Pensions Regulator is currently consulting on a draft code of practice in relation to

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DC schemes, on which the “high eve ” me age i that DC plans should focus on “goo member o tt rn ”.

Note: The consultation closed

on 28th March, 2013, and the

final Code of Practice is awaited.

13. In relation to default investment options, there is no exp icit “ afe harbo r” for an particular default investment option.

14. Rather, the general principles referred to in 1, 2, 3, 7, 8 and 9 above in relation to

investment options will apply to the default investment option.

15. This means that the inve tment con tant’ standard default investment options should not be blindly adopted by the trustee or the employer.

16. Rather, there should be some analysis of the plan membership and those who are likely to end up in the default investment option.

17. For example, if plan members have a low capacity to bear adverse investment outturns (e.g. if they are mainly low paid employees), then the default investment option may be more appropriate if it is capital protected (so, the downside is protected, although the upside is limited).

Note 1: See paper “ n the

Risk of Stocks in the Long n” b Profe or Zvi Bo i (Financial Analysts Journal, May-June, 1995, pages 18-22) as an example of the analysis here. (Cited, for example, in “A e ing Defa t Inve tment Strategies in Defined Contrib tion Pen ion P an ” OECD Working Papers on Finance, Insurance and Private Pensions No. 2 June, 2010 – Pablo Antolin, Stephanie Payet and Juan Yermo).

Note 2: Under the auto-

enrolment provisions of the UK Pensions Act 2008, a plan member cannot be required to

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make a choice of investment option as a condition of becoming a plan member.

F. Legal duties owed (and associated legal risks) in connection with investment choices made by plan members (is there a duty to second guess the member’s investment choice).

Note: I it a to exc e (or tr to exc e) the “pr ent per on” t when investing to prevent having

to econ g e the member’ inve tment choice?

1. In Canada, it is good practice to request reports from the third party plan administrator respecting the number of members who remain in the default fund, and in particular, if possible to ascertain the members who defaulted to that fund rather than actively selected it.

2. If there are a large percentage of members in the default fund, it is good practice to send a special communication out to plan members advising of the risks of not actively selecting investments based on a member’ partic ar circumstances and risk profile.

3. It remains rare for a plan sponsor in Canada to offer members investment advice rather than just investment information, and there appears to be a lot of apathy in plan member groups respecting selecting their own investment options.

See E.1 and E.2 above. 1. Section 34 of the UK Pensions Act 2004 gives the trustee of a UK occupational pension plan the same powers of investment as if the trustee were the beneficial owner of the assets of the pension plan, subject to any restriction on those powers contained in the p an’ Tr t Dee .

2. In the case of a defined benefit pension plan, it is usual for the plan trustee to be given very wide powers of investment (which are then delegated to specialist investment managers to invest in a wide range of different asset classes).

3. In the case of a DC plan, the trustee, in general, cannot take a day to day investment decision itself without committing a criminal offence.

4. Furthermore, the trustee, before taking any investment decision in relation to specific investments, will, generally, need to have obtained “proper a vice” from a suitably qualified investment adviser.

5. Given those constraints, this means that the Trust Deed needs to be structured so that:

5.1 Option 1: The trustee is

required to follow the member’ in tr ction as to the way in which the plan assets which are to be credited to the member’ inve tment account are to be invested within the range of investments which are permitted by the plan Trust Deed (usually, specifically,

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limited for legal risk management purposes), and for the particular investment vehicles to be chosen by the trustee on the advice of a suitably qualified investment adviser.

5.2 Option 2: For the

member to be permitted to link the return on his investment account to a range of investment options on the menu. The trustee then puts in place arrangements to match the member’ choice of how he would like his retirement account linked to arrange for the plan assets to be invested in a manner which delivers the return that flows from the link chosen by the trustee.

Note: This is similar to

the drafting approach in a unit-linked life policy issued by an insurance company.

6. In other words, the drafting approach seeks to preclude the argument that the trustee is required to look at each member’ partic ar circumstances and then invest in a manner which is appropriate, in terms of risk/ reward tolerance, for the member in question.

Note 1: Consider the

example where a plan member’ inve tment acco nt has been invested in a cash option for 10 years (where the capital is protected, but the rate of return after allowing for inflation is seriously negative).

Note 2: In that situation, does

the trustee owe a duty to second-guess the member or to inform the member that the member should think further about his investment decision?

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G. Legal duties in connection with fees charged to members’ retirement accounts (including duty to ensure adequate disclosure)

Note: Can trustees or employers just pass on investment information, particularly associated cost

disclosures received by a trustee/employer from the investment provider or does the employer or trustee have a duty to review the material passed on to plan members?

1. There is little guidance respecting disclosure related to fees, beyond the general requirements of the a mini trator’ fiduciary, which requires openness and candor with beneficiaries. The CAP Guidelines provide that The CAP sponsor should provide CAP members with the description and amount of all fees, expenses and penalties relating to the plan that are borne by the members.

2. Where appropriate, these fees, expenses and penalties may be disclosed on an aggregate basis, provided the nature of the fees, expenses and penalties is disclosed. Where fees, expenses and penalties are incurred by members by virtue of member choices (e.g., transfer fees, additional investment information or tools, etc.) such fees, expenses and penalties should not be aggregated.

3. It appears that there are a lot of hidden fees that may not be disclosed by third party service providers and there is serious concern about the high fee levels charged on mutual fund products in Canada.

4. It is good governance for plan sponsors to review the information on fees being provided to their plan members and question the amount of information provided, and how it is provided (i.e., as a percentage versus as a numerical example), and to regularly review whether there is any opportunity to negotiate for lower fees.

In 2012, DOL finalized regulations providing all plan service providers to disclose fees/expenses charged to plan. Plan fiduciary must review to determine whether service provider disclosed all required information and then distribute to participants in a 401(k) plan.

1. In order for a plan member to make an informed choice as to how to direct the investment amounts credited to his retirement account within the range of investment options available under the plan, the member needs to be given adequate information about the charges that are levied on the investment option in question (so, not just the investment manager’ fee b t the “tota expen e ratio” having regar to custody fees, brokerage fees etc.).

2. The starting presumption is that, under UK Financial Services legislation, the investment product provider would be required to include adequate disclosure of the charges within the promotional literature relating to the investment option in question.

3. If the investment product provider has done so and the trustee/employer just passes on (or provides access to a website where) the information about the investment options, including charges, is available, then the employer/trustee duties would have been discharged.

4. On the other hand, if the investment product provider has not adequately disclosed the charges, the question arises as to whether simply passing on the information without review would be sufficient for the trustee/ employer to discharge its legal duties.

5. That said, in the selection of the investment options in the first place, the investment consultant should have looked at, among other things, the total expense ratio for the investment option in

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question (and that would be part of the ongoing monitoring exercise of the investment option).

6. A possible approach is to include a suitable disclaimer from the employer and the trustee, to the effect that they have not separately checked whether the information about the investment option provided by the investment product provider is correct (as well as to seek a representation and/or indemnity from the investment provider about adequately disclosure).

7. From a “goo o tt rn” point of view, part of the process of selecting an investment option may include some sample checking of whether the product provider does appear to be complying with the disclosure of cost information in a transparent manner.

H. Legal duties owed by trustees and employers to plan members in connection with member communications.

Note: Should these communications explain to plan members (i) the legal nature of the investment

product, and (ii) what would happen if the investment product provider were to become insolvent?

1. There is little guidance in the legislation, however, the CAP Guidelines indicate that the administrator should provide CAP members with sufficient detail about the investment options available in the plan so they can make informed investment decisions.

2. The CAP Guidelines specify that for each investment fund that is an investment option available in the plan, the administrator should provide CAP members with the following information:

the name of the investment fund;

names of all investment management companies responsible for the day-to-day

management of fund assets;

the investment objective of the fund;

1. Legal nature of investment product (trust, mutual fund, hedge fund, separate account) subject to disclosure under DOL regs.

2. Consequences of investment product provider becoming insolvent is not required at the time of investment.

1. No specific requirement to disclosure the legal nature of an investment product imposed by legislation on a trustee or employer.

2. However, where the trustee is dealing with the proper discharge of its prudent person duties, the test will be whether the disclosure of the legal nature of the investment vehicle was material information that should have been disclosed.

3. As a practical matter, the legal nature of an investment vehicle only ever becomes material in an insolvency situation where the investment product provider becomes insolvent (e.g. Lehman and AIG).

4. It is sensible, therefore, to include this disclosure, including what happens on insolvency and details of any

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the types of investments the fund may hold;

a description of the risks associated with investing in the fund;

where a member can obtain more information abo t the f n ’ portfo io holdings, and other detailed disclosure about the fund, etc

3. There are also recommended disclosures where employer securities are offered as investment options and where other types of investments are offered.

4. There is no requirement for a plan administrator to advise members of what the consequences might be if the investment product provider were to become insolvent. It has been a rare occurrence in Canada and there are some insurance protections available.

compensation scheme, in the information about the investment product.

I. Does the employer or person responsible for the governance or operation of the plan have a duty to ensure that the de-accumulation (or retirement) income options are structured and

operated so as to optimise the level of retirement income or should the plan member be left to make his own investigation?

1. There is no duty on the plan sponsor or administrator to assist with the de-accumulation phase apart from some basic disclosures on the member’ option form as to the main choices available to them.

2. The Ontario regulator has information posted on its website to assist members in understanding their options, and this is the case in some other jurisdictions as well.

3. Opportunities to unlock pension monies significantly increased in the last few years across Canada, and this trend may continue in the future.

Employer is not required to ensure adequacy of retirement income provided by a DC plan.

1. In the UK, it is usual, at least at the moment, for a member with DC plan benefits to, at retirement:

1.1 take the maximum amount that he may take as tax-free cash (in summary, 25% of his retirement account, subject to a maximum of one-quarter of the available lifetime allowance (£375,000 reducing to one-quarter of £1.4 million on 6

th

April, 2014 subject to certain grandfathering provisions)), and

1.2 to purchase an annuity with the balance of his retirement account.

2. Where the administration of the plan is provided by an insurance company, it is usual for the insurance company to send out an annuity quotation to the

27


member in the run-up to his retirement.

3. It is a requirement of the Finance Act 2004 that the member is informed that he ha an “open market option” under which he can require the trustee of the plan to purchase an annuity for the member in the member’ own name with an insurance company chosen by the member and with the annuity having particular attributes chosen by the member, but otherwise permitted by the tax legislation (e.g. a level annuity or an annuity which increases each year in line with inflation or a fixed percentage (or inflation capped by a fixed percentage)).

4. However, surveys have shown that a large number of members do not exercise their open market options and, in consequence, end up with annuities which are, potentially, 30% lower than the member could have obtained had he exercised his open market option.

5. There is UK Pensions Regulator Guidance on “Member etirement ption . Occupational DC Schemes – Good Practice in Member Retirement Options and the pen Market ption” (Ma 2008, as updated), which encourages trustees to be pro-active in educating members about the need to exercise their open market option (or at least to investigate it carefully). However, there is a question as to whether the trustee has a positive legal duty to take further action.

20 May 2013

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Volume 80 – May 2014

Documents

IPL - Vol 80 - Philip Bennett Susan P Serota B Bethune A Whiston