Data & Research September 23, 2014

New DC Thinking Based on DB Best Practices

Defined contribution (DC) plan sponsors are already adopting defined benefit (DB) best practices in plan design, but plans could benefit from more DB-like investing and communication.
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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.

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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.

The Markets September 23, 2014

Evolving Practices in Investment Lineup Construction

To let them choose or not to let them choose; that is the plan sponsor’s dilemma when it comes to participants and retirement plan investment options.
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Linda Sandersen, investment consultant and partner at Bellwether Consulting, says plan sponsors fall anywhere on the continuum between “Should we protect participants from bad outcomes and ensure they have assets for retirement?” and “Should we give participants investment choice, let them make their own decisions, and let them live with the outcomes of what they choose?”

Sandersen told attendees of the 2014 Plan Sponsor Council of America (PSCA) annual conference that what drives plan sponsors’ decisions about what to include in their defined contribution (DC) plan investment lineups includes factors such as how savvy participants are as investors, corporate culture, participant demographics, individual investment or plan committee member bias, regulations and fiduciary responsibility, product development, and new trends and innovations. “There is no one right answer; investment lineup is something that is specific to the plan sponsor and its circumstances,” she said.

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There are long-term patterns and there are more recent trends in investment lineup construction. Providing a diversified investment lineup is a fundamental fiduciary responsibility. Sandersen noted that back in the 1980s, many DC plans offered just three funds: an equity fund, a balanced fund, and a stable value or guaranteed investment contract. Then plan sponsors moved to the other end of the spectrum of diversification, sometimes offering so many options that participants suffered from choice overload.

Now the broad trend for diversification is target-date funds (TDFs). “TDFs are a good first step, but there are challenges,” Sandersen said. “Remember, TDFs were designed to help asset managers bring back funds to proprietary products during the open architecture environment, but a bundled product may not be best.” The second wave of the TDF trend is going on currently; plan sponsors are considering custom TDFs. “This is driven by the desire to have more control over the composition of underlying assets,” she contended. According to Sandersen, now there is a surge of plan sponsors using asset-allocation models.

Nancy Blair, director of human resources (HR) at Mohawk Fine Papers, said her firm uses an asset-allocation model. Participants can indicate not only their desired target date, but whether they want high risk, moderate risk or low risk. Their retirement plan assets are allocated among the funds in the plan according to their profile.

Sandersen noted that, through education, Mohawk participants have learned how to use the asset-allocation model.  For example, if a 2030 high-risk fund is not risky enough for them, they can use the 2035 moderate or high-risk fund. Likewise, if a 2030 low-risk fund is not conservative enough, they can move to a 2025 low-risk fund.

The asset allocation model is easier to monitor, added Blair. “It’s just one lineup of funds, instead of a lineup of funds and a target-date suite.”

Another long-term trend in investment lineup construction is index fund expansion. “It’s a way to give participants access to the investable market at lower cost,” Sandersen said. She noted that an interesting wave of the trend her firm is seeing is that once plan sponsors have a broader array of index funds in the plan, it frees them up to make new decisions about active funds in the plan. “Some are choosing more risky funds because they have safety net of index funds, saying ‘Let’s offer something completely different.’”

Collapsing the style box is a long-term trend that can give participants more “meaningful” choice. Some plans may offer a number of U.S. equity options, one non-U.S. equity option and one fixed-income fund option. “What does that tell participants about how to allocate their assets?” Sandersen queried. Or, a plan sponsor may offer a U.S. equity growth fund and a U.S. equity value fund, but participants do not understand growth versus value. Collapsing the style box means a plan sponsor may choose just one small- and mid-cap equity fund and feel that is all participants need to capture the U.S. equity market.

A more recent trend of shifting away from U.S.-centric funds acknowledges the expansion of the investable market. According to Sandersen, the biggest benefit of this trend is the focus on choosing the best investments, regardless of geography. “The best investments are not always domiciled in the U.S.,” she said. “Thinking globally is the best way to think about investment lineup, we think.”

Matthew Perna, a research analyst at Bellwether Consulting, noted another more recent trend is to use more non-traditional, or alternative, assets. He explained that when they say “alternative assets,” it means anything besides stocks and bonds. The thought among plan sponsors adopting this trend is to get a lower correlation to traditional stock and bond funds. “For example, real assets have high inflation sensitivity and are not going to behave like stocks; unconstrained bonds have more wiggle room for interest-rate sensitivity—they can have zero or negative duration. Plan sponsors are also looking at debt instruments and high-yield bonds,” he said. He added that plan sponsors should consider how this fits for participants; the education about how it fits into their investment strategy may be too much of a hurdle to overcome, depending on demographics.

Perna also noted that, at this point, many alternative strategies do not have the scale of traditional stock funds, so they have higher fees. Plan sponsors should ask whether they can justify the additional expenses. It is also harder to do due diligence and peer group benchmarking.

An emerging trend Bellwether is seeing is alternatives to TDFs. More and more managers are changing strategies; new strategies are being introduced that have a more unconstrained glide path. Providers are saying they can do it for participants, and can make use of their knowledge of the market. However, Perna warned that Bellwether recommended these investment options would be more of a complement to a traditional TDF at this point. “If you have more savvy investors that care about the limitations of TDFs—for example, someone in a 2050 fund that is more conservative—they could use a TDF alternative.”

Sandersen said plan sponsors work so hard choosing the proper investment lineup, but their reasons are often lost in communications with participants. “We believe very strongly that the underlying theses used to develop the investment lineup are what should be communicated to participants,” she told attendees. “This helps participants use the lineup in the best way for them.” 

Blair added that plan sponsors should continue to monitor their fund lineups. Mohawk added a socially responsible investment (SRI) to its fund lineup based on the values of the company and employees, but after some time, it was only used by two people, so they dropped it.

About communications, she noted that changing Mohawk’s fund lineup brought some attention to the plan from some employees that were not participating.

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