The Markets March 27, 2015

An Opportunity for Liquid Alternatives in DC Plans

As plan advisers are increasingly focused on new strategies to improve plan participant outcomes, liquid alternatives may present an opportunity to diversify retirement portfolios.
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In a paper, “Liquid Alternatives and the Opportunity in Defined Contribution Plans,” from Pershing Prime Services’ Executive Insights series, Mark Aldoroty, head of sales and relationship management for Pershing Prime Services, and Rob Cirrotti, head of retirement solutions at Pershing, say the increased returns and hedges that reduce risk in liquid alternatives can have a significant impact to participant outcomes over time.

The paper suggests that the best fit for liquid alternatives in a defined contribution (DC) plan is within a target-date strategy or advisory model. “You can’t throw these investments into a DC plan lineup and expect plan participants to figure out what to do with them,” the paper says.

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To make a liquid alternative offering attractive to a DC plan, advisers need to examine what reasonably converts from the hedge fund space to the DC plan space. The strategy needs to feel like a daily liquid product. The paper notes that DC platforms are evolving to accommodate these strategies.

Advisers need to educate DC plan fiduciaries about the benefits of liquid alternatives to plan participants. Some fiduciaries may be completely unfamiliar with these strategies. Because these strategies are relatively new and do not come with a decades-long benchmarking history, there needs to be fact-based education for all DC plan decisionmakers, the authors contend—plan fiduciaries, as well as advisers. They need education about hedging and non-correlated risk. While there is not yet definitive proof that liquid alternatives improve retirement plan outcomes, advisers can look to how these vehicles have helped in other areas of investing and correlate that to retirement plans.

The paper contends DC plan fiduciaries need to change their focus from investment selection risk to retirement adequacy risk. They are increasingly going to be judged on results participants achieve, so they should shift their thinking toward offering investment options that can produce better outcomes.

“While the role of a DC plan fiduciary remains the same, in providing prudent investment decisions, the investments to consider are ever changing. With the growth of alternative investments, DC plan fiduciaries need to educate themselves on new products and how they will, or will not, fit into their DC plan investment menu,” the authors conclude.

The paper may be requested from here. A free registration is required.

Data & Research March 27, 2015

Procrastinators Exhibit Suboptimal Retirement Savings Behavior

Procrastinators do not exhibit optimal retirement savings‐related financial behaviors, research finds, leading to worse preparedness by the retirement date.
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According to Jeffrey Brown, of the University of Illinois at Urbana-Champaign, and Alessandro Previtero, of the University of Western Ontario, their research provides “new and robust empirical evidence that procrastinators behave differently than non‐procrastinators for five important retirement‐related financial behaviors.” The paper defines a procrastinator as an individual who waits until the last day of their health care open enrollment period to make their plan election—a real-world metric the researchers suggests is more informative and reliable than qualitative definitions of procrastination.

Using three separate administrative data sets, the researchers show that procrastinators defined this way are (i) less likely to participate in a supplemental savings plan; (ii) take longer to sign up for 401(k) plans; (iii) contribute less; (iv) are more likely to stick with default portfolio allocations, regardless of their appropriateness; and (v) are less likely to take the annuity payout option from their defined benefit (DB) plan when offered a lump-sum payout.

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“Further evidence shows that these findings are best explained by procrastination being the outcome of present‐biased preferences, consistent with the predictions of leading economic models of procrastination,” the research report says.

The paper notes that this finding is not new. “The idea is certainly intuitive,” the researchers explain. “Planning for retirement involves near-term actions with distant consequences, and it is easy to put it off when faced with more immediate temptations or demands on one’s time. Indeed, the trade‐off between near‐term costs and distance consequences is the reason that economists treat procrastination as a stemming from present‐biased preferences.”

The researchers say, however, there has been very little empirical research to confirm or refute the idea that procrastination has a meaningful effect on financial security in retirement, “and virtually no empirical work showing that procrastination arises from present‐biased preferences.”

They feel their paper fills this void by providing more robust evidence that procrastinators behave differently than non‐procrastinators when it comes to major actions related to financial preparation for retirement. The paper also discusses why the existence of present‐biased preferences is the only theory that is consistent with the entirety of the team’s empirical results—namely by ruling out alternative stories, including optimal delay, rational inattention, or the basic notion that individuals may simply be busy or disorganized.

“For example, we use data on the frequency of interactions with the plan election tool to separate optimal delayers from procrastinators, and show that our results are being driven by the procrastinators,” the paper explains. “We also do a stylized calculation to show that these are consequential decisions, which casts significant doubt that rational inattention could explain our results. We also discuss that a subset of our results—those related to contribution rates conditional on saving, and those related to annuitization—are consistent with present‐biased preferences and not alternative stories. In the end, the only hypothesis that can explain the entirety of our results is that individuals with present‐biased preferences are more likely to procrastinate, and this combination of preferences and behavior lead them to behave quite differently from non‐procrastinators when it comes to preparing for retirement.”

A key advantage of this research approach is that the consequences of underlying decisionmaking by pre-retirees are real rather than hypothetical. In particular, both health care plan elections and retirement plan choices are financially consequential, which increases confidence in the external validity of the findings.

“Another nice feature is that the health care plan election and retirement plan choices are similar enough for the health care plan election behavior to be informative,” the paper concludes, “but not so similar as to introduce any mechanical correlations with our outcomes of interest.”

The full paper is available for download here.

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