Defined Contributions – Still several risks attached

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With so many companies still licking their wounds as the result of continuing pension fund deficits, it is hardly surprising that new schemes tend to be of the defined contribution variety whereby the only thing guaranteed is the employer’s contribution rather than the benefits payable on retirement.

However, although the major risk of not having sufficient funds to meet eventual pension commitments is removed by having a defined contribution scheme, there still remain several risks of which employers and trustees need to be aware.

Improvements in longevity continue to chip away at annuity rates and therefore the amount of annuity that can be bought on the dates originally planned by retirees. Where pension fund members are in drawdown situations in which buying annuities is not an issue, the burden of risk is transferred on to their shoulders since variations in life expectancy mean that they may be in danger of either running down their funds too early or leaving excessive balances on death.

Another major risk which remains particularly topical is the historically low level of interest rates and the effect of quantitative easing. The prevailing level of rates is clearly going to bear down on annuity rates and further threaten those who are obliged to purchase annuities within a prescribed timeframe.

Clearly, a significant area of risk revolves around the pension fund managers themselves. Trustees and employers need to be especially vigilant when it comes to obvious potential hazards. Are all records especially those relating to members’ contributions protected against catastrophic computer failures, flooding and fire etc.

Similarly, are the managers financially secure themselves? What is the risk that they might display negligence in financial management or take inappropriate investment decisions involving such items as unhedged positions on options, derivative instruments or investments which are wholly inappropriate from the point of view of risk or timescale?

There is also a risk in times of low economic growth and low bond yields that rises in administration and management charges represent an unduly high percentage of overall investment returns and jeopardise long term projections for fund performance at the net level.

Finally, in common with most pension funds, defined contribution pension schemes remain at the mercy of unforeseen politico-economic events that can affect long term investment performance. Employers need to remain alert to possible political changes which might usher in measures detrimental to the rate of return on pension fund investments. These may be as a result of changes in taxation or regulations affecting the pension industry. In extremis, they may involve sequestration of assets along similar lines to the recent raid on bank deposits in Cyprus.

This helpful business advice was sponsored by Baker Tilly. For more information about defined contribution pension schemes please visit http://www.bakertilly.co.uk/sectors/Pages/definedcontributionrisk.aspx

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