Dealing with auto-enrolment and default option risk

Speaking at a pension seminar on Thursday in Toronto, Randy Bauslaugh, a partner with Blake, Cassels & Graydon LLP, outlined the unique hazards faced by DC plan sponsors who utilize auto-enrolment and target date fund defaults.

“I think they are good ideas,” he said. “The bad news is there are some legal issues. The good news is that—while you can’t eliminate the legal risks entirely—these are all manageable.

Auto-enrolment
Bauslaugh explained that while many jurisdictions specifically permit auto-enrolment into a DC plan in order to increase member participation, certain religious groups—such as Mennonites—are against it, and have special exemptions under the Canada Pension Plan. Plan sponsors must be sensitive of such beliefs before enrolling staff into a plan.

Contributions by payroll deduction
Almost every jurisdiction in Canada (except Quebec) requires employers to get specific consent from plan members in order to deduct pension contributions from their pay, said Bauslaugh, and failure to comply can result in substantial fines.

“Unfortunately, these rules across the country are not very consistent, and in some jurisdictions you have to be more specific than in others.” To make matters even more complicated, these obligations are constantly changing, requiring vigilant monitoring.

Auto-escalation
From an economic perspective, Bauslaugh believes automatically increasing the contributions of a plan member over time is a great idea. But from a legal perspective, he says you’d better be careful about getting the appropriate consent. Employers can either get consent every time you escalate or when an employee is initially hired, where they can be given a schedule displaying when escalation will occur and by how much.

Risk management
To lower legal risk associated with auto enrolment, employers should:

• provide clear disclosure prior to employment commencement;
• comply with legal regulations relating to payroll deductions in contributory plans;
• understand and monitor legal obligations;
• provide clear, unequivocal and frequent disclosure; and
• know that they cannot likely eliminate all legal risk.

Target-date funds
Bauslaugh explained proponents of target date funds (TDFs) consistently point to the popularity of these products in the U.S. However, that does not mean they should be a default offer to plan members.

In his experience, Bauslaugh has heard many reasons to offer TDFs, many of them wrong. His top five wrong reasons for using TDFs in Canada are:

1. Investment options must be offered to comply with fiduciary duty/CAP guidelines.
Wrong, he said. “The CAP guidelines don’t say you even have to offer investment options. They just talk about what happens IF you do.”

2. Plan sponsors need to choose a default to enhance their employees’ potential to achieve the highest possible retirement assets.
“I don’t think that’s right in Canadian law, but it’s right economically,” he said.

3. Plan sponsors can feel confident in meeting the fiduciary duties by using lifecycle funds.
If you’ve done the design, governance, and implementation phases correctly, you can feel confident about meeting fiduciary duties, he said. But not just by choosing the lifecycle fund.

4. In the absence of legislation there is no right or wrong answer for selection of the default investment option.
He believes the correct version should say there is no right answer. “There are only wrong answers because our legislation leaves huge gaps.”

5. To meet fiduciary standards, the decision-making process for determining default characteristics should not be driven by preservation of capital.

The correct legal reason for offering a TDF, according to Bauslaugh, is to achieve the purpose of the plan.

Default option
Employers should know the risks of default options, summarized by Bauslaugh as follows:

• the “catch-22” risk of failure to preserve capital versus failure to earn a reasonable rate of return without undue risk of loss.
• the “one size fits all” risk, in which risk profiles of any two people with the same retirement date are not necessarily the same.
• the “power of suggestion” risk, when the employer’s choice suggests this is the best investment option.
• the “failure to communicate” risk, regarding communications on the purpose of the plan, nature of the default option, and misunderstanding about the nature of default.
• “monitoring” risk, in that it is difficult for plan sponsors to monitor underlying funds, asset allocation and reallocation.

“This is an issue that cries out for legislative clarity; namely safe harbour rules such as those set up in the U.S. and U.K.,” he said. “In the absence of such legislative protections, there are only potentially wrong legal answers for default option selection.”

“In other words, employers can be sued for providing lifecycle funds as default options and they can be sued for imposing conservative options that simply preserve capital. Accordingly, and until governments respond, sponsors and administrators need to be continuously vigilant in all aspects of design, implementation and governance of default options, especially lifecycle defaults.”

Bauslaugh explained there are many practical steps employers can take to help protect themselves from lawsuits, such as setting legally appropriate written objectives, obtaining appropriate written agreements with providers, monitoring costs, and regular ongoing evaluations. “In this continuum, diligent plan member communication is likely to be the most vital aspect of legal risk mitigation.”

To comment on this story, contact us.