More than ever, good governance, smart management crucial

The rapid growth in defined contribution (DC) plans began in the early 1990s, coinciding with one of the strongest bull markets in history.

The recent slowdown in financial markets, coupled with highly publicized scandals involving the DC plans of some major U.S. corporations, are causing some DC plan sponsors to question whether they are doing the right thing.

In fact they are. DC plans are an appropriate choice for many plan sponsors, but the challenges need to be managed carefully.

The defining feature of a DC plan is that members bear the investment risk. However, the plan sponsor continues to bear the legal and business risk associated with operating these programs. These risks can leave plan sponsors open to future legal challenges as a result of:

•improper selection and monitoring of plan investments which can result in less than optimal decisions;

•insufficient recordkeeping;

•failure to provide the members with the education tools necessary to make effective decisions;

•failure to implement an effective governance system and monitoring process; and

•failure to comply with regulations governing DC plans at a time when regulators are showing increased interest in DC plans.

In addition, failure to design a plan that meets company and member objectives can lead to employee dissatisfaction and workforce retention issues.

A recent global survey of DC plans, conducted by Mercer Investment Consulting, looked at current practices and revealed areas where governance and management can be strengthened to help minimize risks for plan sponsors.

In 1999, Mercer conducted a comprehensive survey of DC plans across Canada. Building on the 1999 survey and the strong growth in DC plans in most major markets globally, the 2002 DC survey was conducted online across Canada and in nine other countries with more than 1,600 respondents, including 310 in Canada.

Survey respondents included a broad cross-section of employers representing all major industry groups and types of organizations varying in annual revenue size. Plan assets ranged from $50,000 to more than $2.6 billion with a median plan asset size of $8.8 million and a median of 400 plan members. The survey examined how DC plan sponsors are managing areas of risks and assessing the success of plans.

Governance: Respondents were asked about the allocation of responsibilities under the DC plan between the human resource function and the finance function. Forty-seven per cent of Canadian plan sponsors said HR had more influence over operational decisions, even when dealing with investment-related issues, including investment strategy, manager selection and manager monitoring. This points to a significant difference in practice compared to defined benefit plans, where it is rare for finance not to be involved in investment decisions.

Investment monitoring: The recent uncertain investment environment appears to have had some influence on governance policies in Canada. The number of sponsors with formal governance and monitoring committees now stands at 73 per cent, compared to 68 per cent in the 1999 survey.

Almost 90 per cent of plan sponsors review investment performance at least once a year. However, only 60 per cent of plan sponsors conduct an annual qualitative review of investment managers. A qualitative review of an investment manager would include factors such as changes in ownership, key personnel, assets under management, investment style and investment process.

These factors are often better predictors of future operational problems than past performance.

As expected, governance practices tend to vary depending on the size of the plan, which may reflect a conscious or unconscious risk assessment by plan sponsors. If more money is at risk, potential liability is higher and a higher level of diligence is required in overseeing the plan. This may also reflect a lack of available resources in smaller organizations.

Plan design: Based on the 2002 survey results, the average contribution to DC plans by Canadian sponsors is 4.7 per cent of pay. This is higher than the median contribution for plans in the United States, but lower than the median in many other countries. The most common design favoured by 53 per cent of Canadian respondents matches employer contributions with members’ contributions.

Investment options: The average number of investment options currently available to Canadian plan participants is 13. The prevalence of passive funds is high with 76 per cent of respondents offering a passive fund in at least one asset class. A passive fund replicates an underlying index. For example, a passive Canadian equity fund would mirror the same stocks included in the TSX300 and no stock selection is required.

Recordkeeper monitoring: No facet of a DC plan affects members more dramatically and immediately than recordkeeping and administration services.

Poor recordkeeping can undermine employee confidence in the plan and reduce its perceived value. Periodic record monitoring is a critical component and approximately 60 per cent of survey respondents have a formal mechanism in place for reviewing the performance of their recordkeeper.

Recordkeeper evaluation: Service was identified as the single biggest factor in evaluating the recordkeeper of a DC plan. In Canada, the next two most important evaluation factors were quality of reporting and quality of communication with plan participants.

Communication: The survey results reflected a huge increase in reliance on the Internet as a communications tool. In the 1999 survey, 54 per cent of the respondents rated interactive voice response (IVR) systems as an important communication tool, while only 21 per cent considered the Internet to be an important source of information to members. This trend reversed in the 2002, which can be attributed to the improvement in and availability of Web-based tools.

Evaluating success of financial education programs: Very few companies reported formal surveying of employees to assess the success of financial education programs. Instead, they rely on indirect information, such as levels of participation and informal employee feedback.

An effective communication and education program is key to managing a DC plan successfully. Direct employee feedback provides valuable information on the effectiveness of existing communication programs.

In spite of the current investment environment, the features that originally attracted sponsors to DC plans remain valid today, including a reduced ongoing administrative burden and predictable long-term costs.

Canadian plan sponsors can take comfort from the existing investment trends. Mercer’s 2002 survey results indicated that the most used fund under a Canadian DC plan is the balanced fund, a mix of stocks and bonds.

During the four-year period ending June 30, 2002 — which includes the current bear market — the median balanced fund manager in Mercer’s Canadian Pooled Fund Survey had an annualized return of 4.8 per cent. While this can’t be considered ideal, (reasonable long-term expectations are closer to seven or eight per cent) it could be worse since it is still running ahead of inflation.

In the current climate, DC plans sponsors should review the governance and management of plans. They should assess whether policies and processes are in place to educate employees and to address governance and operational risks. Good governance and successful plans go hand in hand.

Colin Ripsman is a principal at Mercer Investment Consulting, the investment consulting operation of Mercer Human Resource Consulting. He can be reached at [email protected] or (416) 868-2000. Oma Sharma is an associate at Mercer Investment Consulting. She can be reached at [email protected] or (416) 868-2000.

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