Improvements that can be made in the defined contribution system include higher expected returns on investment for the same risk, Robert C. Merton told attendees of the Plan Sponsor Council of America (PSCA)’s 2014 National Conference. “We can’t dictate this, but we need to make sure investments in DC plans are at least as effective as investments in DB plans,” he said. “When choosing investments, plan sponsors should use the lens of, ‘How will this produce similar rates of return and risk as we enjoyed in DB plans?’”
Merton, a School of Management Distinguished Professor of Finance at The Massachusetts Institute of Technology, and resident scientist at Dimensional Holdings Inc., believes goals-based investing will increasingly be a trend in defined contribution asset management. An example of that is liability-driven investing (LDI) in pension plans. “Look at what you promise people and invest toward that focus. The cost is they won’t get anything more than that goal. DBs promise a benefit, not a benefit or more,” he noted.
According to Merton, the first step is that DC plan participants need to know what goal to set. He notes that even the high-IQ colleagues he works with do not know what they will require in retirement. “It’s not being paternalistic when we help set goals for participants, we are helping them solve a very complex equation,” he contended.
Merton listed key criteria that he said should be part of any defined contribution plan's design, without which he believes the design is deficient:
- Set a retirement replacement income goal, not a wealth accumulation goal. “DB plan benefit statements tell you the benefit you will receive in retirement, not your total account balance. Social Security also tells you a benefit, not an account balance,” he pointed out.
- Offer robust, scalable, low-cost investment strategies that make use of all dedicated retirement assets to maximize the chances of achieving that retirement income.
- Manage the shortfall risk of not achieving this goal.
- Be effective for participants who are and remain completely unengaged.
- Individually customize goals for each participant based on salary, age, gender, plan accumulation and other retirement-dedicated assets.
- Integrate all sources of retirement savings into an individually tailored dynamic portfolio strategy informed by changes in the market and personal conditions. Merton noted this is a problem with target-date funds (TDFs); they are designed for the “average” participant. "A 34-year-old male who makes $40,000 per year needs to invest differently than a 34-year-old female who makes $100,000 per year," he said. He likened TDFs to offering size-9 shoes to a room of people whose shoe sizes range from six to 12.
- Provide only meaningful information and choices with easy implementation to participants who do engage. “Showing them what has happened to their income potential is more meaningful than showing them the rate of return on investments,” Merton argued.
- At retirement, offer a seamless transition from the accumulation phase to the post-retirement payout phase, with flexible options to combine annuities, long-maturity government bond portfolio, risk asset portfolio for goal-based future real income growth, and deferred annuities to start at age 85 as “tail risk” insurance for longevity, according to the individual retiree profile.
Just as DB plans must focus on their funded ratio to be sure they are able to pay the promised benefits, so too should DC plan sponsors worry about a “funded ratio”—the amount of retirement income the current account balance could buy. Merton explained that if the target replacement income goal for a participant is $70,000, and the current account balance could buy replacement income of $49,000, the funded ratio is 0.70 or 70%. The participant’s account is fully funded when the account balance can buy $70,000 of annual income in retirement.
One improvement to the DC system would be to get more income from the assets participants have, Merton said. Longevity annuities allow for a larger payout at a later age in return for giving up assets at death. Reverse mortgages can also be presented to participants at the time they make choices about withdrawal strategies. Merton noted homes are typically the largest asset for middle-class individuals at retirement.
Finally, in addition to new thinking about DC plan investing and participant communications, Merton recommended plan sponsors offer participants a one-time review of their retirement account with a financial adviser.