Lessons Learned About DC Plans

A new study has identified common practices for plan success in defined contribution (DC) retirement plans around the world.

“Lessons Learnt in DC from Around the World,” conducted by UK-based asset manager Schroders, found that globally, recurring themes with DC plans include the need for: plan participation and sufficient contributions to be compulsory, through features such as automatic enrollment; contributions of at least 15% of salary and real investment returns of 3% annually as the minimum to produce an adequate standard of living in retirement; and funds that target above-inflation returns (at least 3% real).

However, Lesley-Ann Morgan, head of Global Strategic Solutions, Schroders, London, told PLANADVISER the biggest differences between DC plans in the United States and others around the world include:

  • Target-Date Funds: The use of target-date/lifecycle funds is not as common in other countries as it is in the United States. Some countries, such as Hong Kong and Mexico, have risk-graded funds and others, such as Australia, do not use this approach at all. “While we applaud the idea of managing the asset allocation for participants that are not engaged or able to manage their own assets, U.S. target-date funds seem to have become excessively complex, especially when it comes to benchmarking,” Morgan said, suggesting that plan sponsors stop and assess what participants need from their assets and whether the current design of target-date funds provides this.
  • Level of Diversification: While diversification in defined benefit plans is a concept that is accepted and pursued in many plans around the world, this has not translated as well in DC, Morgan noted. “In some countries, such as South Africa, this is because regulations have prevented full diversification. And in the United States, the daily priced retail environment is often used as the reason why diversification has been slow to be embraced,” she said. She added that research suggests this may also be cultural, with Americans being famously supportive of equity investment. However, large losses from equities can be a significant concern for participants. Research observed that some large U.S. 401(k) plan sponsors are starting to design their own target-date and diversified funds, a trend also seen in the UK.
  • Contribution Rates: “As 401(k) represents a higher proportion of an individual’s retirement income over time, we believe that the current rate of around 6.5% combined employer and employee contributions is unlikely to provide a standard of living that many need or want,” said Morgan. Research observed that the United States also does not have compulsory DC provision unlike some other countries (such as Australia, where the contribution rate is rising from 9% to 12% by 2020). Again, she said, culture may play a part in the amount that is contributed, with U.S. plan participants often preferring to consume now rather than save for later, unless they are forced to.

Morgan recommended actions U.S. DC plan sponsors should take:

  • Better Diversifying Asset Allocation: “Large capital losses for 401(k) participants can be problematic both in terms of the impact on their DC account balance and the action they may take as a result of suffering a large loss, such as reducing contributions or changing asset allocation inappropriately,” said Morgan. One of the key ways to mitigate this volatility, she said, is to better diversify the asset allocation into alternatives using a diversified growth approach. This approach has been better utilized in Scandinavia, Australia and the UK than in the United States. “Offering participants multiple U.S. equity funds does not represent good diversification,” she said.
  • Active Management of Asset Allocation to Better Mitigate Losses: “Plan sponsors should be aware of the difference between time-weighted and money-weighted returns. Losses and gains incurred later in life, when the DC account is larger, have a much more significant effect than those incurred earlier,” said Morgan. According to research by Schroders, the timing of gains and losses for a member has a significant impact on their DC account balance at retirement and therefore whether they are likely to achieve their goals. “Participants need to hold onto growth assets as long as possible but want to avoid large losses close to, and in, retirement. Diversification and downside risk management tools can be very beneficial in mitigating against these large capital losses,” she said. Plan sponsors should also be aware that there are a large variety of downside risk management tools and some create a large drag on returns. Morgan said the findings of the study point towards an active management of the asset allocation to avoid large drawdowns and a systematic braking approach that kicks in if a very severe market event occurs.
  • Factoring in Inflation to Retain Purchasing Power: “The things that retirees will need or want to buy in retirement are likely to increase with inflation between the time that participants save for them and need to pay for them. For this reason, we advocate a diversified approach that targets a return above inflation so that participants' assets retain their purchasing power,” said Morgan. This is a tricky target for managers to manage effectively against, she said, and plan sponsors need to recognize that this is a long-term target. Secondary, shorter term targets can also be used to judge the success of the manager.
  • Re-Evaluating Fixed-Income Options: Morgan believes many plan sponsors have not recently re-evaluated the fixed-income investment option they offer participants. Since market conditions have changed markedly since these options were selected, plan sponsors need to ask if these options will still continue to deliver in the current market conditions.

A video of the study being discussed by Morgan can be found here.