The fluidity in the job market may generally be a positive for some but it presents a challenge for employers running DC pension schemes.

The concept of a defined benefit (DB) pension legacy, and the risks associated with it are well-known.

However, legacy issues associated with defined contribution (DC) pensions tend to pass unnoticed, despite having the potential to be a major drain on financial resources for employers in the future.

The model where employees worked for most of their career for one employer is broken. Now people tend to move through several jobs throughout the course of their career.

Whilst from many perspectives this fluidity in the job market is a positive thing it presents a challenge for employers running DC pension schemes. They are faced by the prospect of employees joining their pension schemes, and then moving on to another job after only a short stay.

This is onerous for employers because they ultimately have responsibility for an employee’s DC pension right up until they retire regardless of how long the person worked for the employer.

From an FD perspective there are cost implications. Typically, in a DC plan, the employer pays for the administration whilst the members are responsible for paying the investment management charges.

However as the administration bill is based on the number of people within the DC scheme, the employer ends up footing the bill for current employees as well as for all the employees who have left the scheme (right up until retirement).

Employers may well find that they have as many deferred members as current. Clearly, given the challenges of the current financial crisis, FDs should heed the warning.

In economic times marked by major cost-cutting, the DC legacy burden has the potential to be a cash drain for employers and one which was not intended and without any advantage for employers.

According to Towers Perrin’s recent corporate pensions survey, 29% of companies saw the need to lower pensions costs as a serious concern.

What all of this means is that costs will rapidly mount up, despite the fact that some of the pension’s pots will actually be relatively small.

When you look at administration charges, small pension pots are just as expensive as large ones, with one survey finding the average cost coming in at about £95 per person per month. To make matters worse, these costs are more likely to increase than decrease.

Tighter governance demands imposed by regulators are looming which will force employers to adhere to more frequent communication, more member services and regular investment reviews. Of course these demands come at a price, as more stringent administrative demands are likely to drive up costs.

The introduction of auto-enrolment to pension schemes from 2012 will only exacerbate this problem. For some employers in industries such as services and retail where current take-up is low auto-enrolment may have a profound impact on the numbers of members, perhaps increasing membership for 25% of the workforce to around 80%.

This new audience for pensions may be just the group who are more likely to quickly move on leaving behind a small pension pot for the employer (and the trustees) to look after until they reach retirement age.

The whole issue around DC legacies stems from the fact that employees do not transfer their pensions pots with them as they move between jobs. In the US, legacy DC burdens aren’t such a problem, as employees rollover their pensions pot into the new employer’s scheme.

What this means is that throughout the course of their career, a US employee typically moves their pension pots with them, allowing them to draw benefits from one scheme when they retire.

This is possible because they have a straight-forward, simple and effective system and employers who encourage rollover are free from fears about giving financial advice.

However, this practice isn’t common in the UK, even though it is technically possible. One of the key stumbling blocks is the sheer variety of different plans available in the UK and the diverse complications associated with them, e.g. contracting out. We also do not have employers who are motivated to play their part in this – perhaps for well founded reasons.  Employers don’t have incentives to invest effort in helping the rollover process.

But until we reach that point, employers will be forced to ponder hard about whether the administration costs of their current arrangements are the best use of hard won company cash resources.

Potential solutions might include:

1. Shift current employees to a contact-based scenario, where the providers manage future legacy DC members, removing some of the burden away from the employer. (However, DC members can’t legally be moved into a contract scheme once they’ve left the company in question, so this only works for current and future staff).
2. Outsource the administrative side by moving employees into Personal Accounts after the introduction of auto-enrolment from 2012.
3. Use a third party to take care of the legacy problem. Although employees who have left the company can’t be moved into a contract arrangement they can be moved into another pension scheme altogether, to be run by a third party, removing the governance challenge.

Presently, most sponsors will be focusing on the risks associated with their DB legacy, which is today’s main problem. But although damage from DC legacies hasn’t really been felt by employers just yet, they do need to be one step ahead of the game if they are to stop DC becoming a major legacy challenge in the future.