Are DC Trustees liable for the investment choices of their members?

Updated December 2011

Defined Contribution (DC) scheme rules often allow members to choose the way in which their DC "pots" are invested, typically from a list of managed funds that have been approved by the trustees. Where the member makes no choice, the rules will provide for the pot to be invested by the trustees, who will allocate it to a default fund, often a "lifestyle" fund, in which exposure to risk is progressively reduced as the member approaches his target retirement age.

Surveys show that around 90% of DC members tend to leave the business of investment to the trustees, so for the most part they end up in a lifestyle fund. However, in this briefing we focus on the issues that arise where the member does make his own choices, and later regrets them. Will the member or their dependants be able to blame the trustees?

DC "pots" are still trust money

The key point to remember in DC investment is that, even though each member has his own "pot", the money is still trust money. In fact the rules may make it clear that the member's pot is only an artificial concept designed to provide a basis for the calculation of the member's benefit. So when a member makes an investment choice, he is in reality making a decision about the investment of trust money, and is doing so on behalf of the trustees.

Can trustees delegate investment decisions to their members?

Most scheme rules give the trustees wide powers to delegate their functions to others, as well as providing them with a shield against potential liability, in the form of an exoneration clause. On that basis, it appears that trustees should be able to delegate their investment functions to members without fear of repercussions. However, it is not that simple.

Regardless of what their rules may allow, trustees may only delegate their discretion to make investment decisions to an appropriate fund manager (broadly one who is authorised by law to do that kind of business), and then only on the basis that the delegation is made subject to the trustees' investment duties.

Trustees' investment duties

Above all, trustees must act prudently. They must also act in beneficiaries' best financial interests (i.e. not put ethical or social concerns above their duty to get the best financial return they can prudently obtain). Before making any investment, they must obtain and consider "proper advice" (i.e. usually from an appropriately authorised person). In addition, they must invest "in such a way as to ensure the security, quality, liquidity and profitability of the portfolio as a whole", and must diversify in their selection of asset class, so as to avoid an excessive reliance on one particular asset class, issuer or group, or accumulations of risk in the portfolio as a whole.

In the circumstances it is not surprising that the law restricts the extent to which these duties can be delegated.

No "get-out" clause

In addition, liability for breach of any duty of care or skill in carrying out any investment functions cannot be excluded. The exception is where that duty has been delegated to an appropriate fund manager and all reasonable steps have been taken to make sure that the fund manager has the appropriate knowledge and experience, and is acting competently.

When you boil this all down, it means that trustees who allow members to choose investments are delegating their powers in breach of the 1995 Act, and in the circumstances will remain liable for any breach of their investment duties that causes loss to a beneficiary. Even where the member's choice is confined to a list of funds selected by the trustees (or their authorised investment advisers) on rigorous criteria, the choice made by each member is still an investment decision.
If it were just the member who stood to lose by his own actions, then one might be tempted to think "so what?". But this ignores the fact that the member may well have dependants who have a contingent interest in his "pot".

But everyone's doing it!

The current climate is certainly in favour of member choice. The Pensions Regulator has issued this statement, indicating that member choice is considered legitimate, if responsibly handled:

• Key issues for trustees and providers to focus on are their processes for appointing and monitoring investment managers and the range of funds they make available to members.
• We're considering whether it would be beneficial to issue guidance on investment practices such as the selection of investment managers and fund choices.
• In a trust-based scheme, it's for schemes to determine their investment strategy based on their own circumstances, taking into account factors such as the membership profile and the scheme rules.

This means that although members have the ultimate responsibility to choose from among the funds on offer, trustees have responsibility for determining the overall strategy and the funds to be offered.

However, regardless of the attitude of the Regulator, it is the risk of a claim by a member or a dependant that the trustees should watch out for.

What should trustees do?

There are various solutions:

• Abandon member choice and adopt the default approach for everyone, with a lifestyle fund to cope with changing needs as members approach retirement. The vast majority are already covered by this approach. However, this would be a difficult "sell" to members of a scheme which already has member choice, and could be seen as a retrograde step.
• Make the member's choice discretionary for the trustees, and for each choice to be subject to professional scrutiny before it is actioned. This may well involve the member in an assessment, similar to the "know your client" process which financial advisers must follow. That would of course be expensive, and of limited appeal to employers.
• Get the member to sign a disclaimer. This in itself will need careful drafting, and may not be proof against the claims of dependants.
• Abandon the whole notion of a trust-based DC scheme, in favour of a contract-based arrangement, where the concept of breach of trust does not arise. This is a radical approach to take; however, there are signs that even these arrangements will become increasingly regulated, and may end up looking a great deal more like trust-based arrangements than they do currently.

What is really needed is a change in the law, but until that happens, trustees should be very wary of providing members with investment choice.

Next steps

Where scheme rules already provide for member choice, we strongly recommend that they be checked and a risk assessment carried out. We do not think it will be too long before a disgruntled member (or his surviving partner) brings a claim against DC trustees for failing to prevent him from investing his pension pot unwisely.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at December 2011. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

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