Think Outside the Style Box in DC Plans

If it’s a defined benefit (DB) versus defined contribution (DC) race, DB is in a 180-basis point lead, contends BNY Mellon. 

Pointing to data from the Callan DC Index, Rob Capone, head of retirement business at BNY Mellon, said there has long been a performance disparity between defined benefit (DB) and defined contribution (DC) plans. One sticking point in DC plan design is the traditional style box approach, which Capone feels, does not provide enough diversification and risk balance for plan participants. Even within target-date options, DC plan participants may not be able to meet their retirement goals using traditional DC allocations.

“When you compare the two, you see DC plans are 60% allocated to U.S. equities,” Capone told PLANADVISER. DC plans have limited diversification and significantly more exposure to equities than DB plans. The combined U.S. equity and U.S. fixed-income allocations in DC plans account for about 80%, compared with just 60% in DB plans, pointing to a marked home-country bias in DC plans.

The difference is the amount of exposure to non-traditional investment categories that lie outside the style box, Capone said. For low-correlated, non-traditional diversifying categories, the average DB plan has nearly 20% allocated to a combination of alternatives, real assets and emerging markets (both equity and debt), compared with minimal exposure to these asset categories in the average DC plan, BNY Mellon found in its research. 

BNY Mellon also noted poor and ineffective asset-allocation strategies among active contributors. The investment policy statements of many DC plans continue mandating that investment options be highly concentrated in traditional style box categories.

How this plays out in returns, Capone said, can be seen in data from the Callan DC Index, which showed that the average DB plan outperformed the average DC plan by more than 180 basis points since the index was initiated in 2006.

While keeping simplicity—for plan sponsors as well as plan participants—in mind, Capone said that BNY Mellon is taking the realistic view that more and more, DC plans will replace DB plans as the dominant retirement vehicle. “It’s time to adopt some DB-like institutional investing practices,” he said. “Let’s look at some opportunities to adopt DB practices and ask what some of the commonalities are between DC and DB plans?” 

Too High an Equities Allocation?

Plan advisers should ask themselves what they are trying to accomplish with their plan sponsor client, Capone said. “What is your goal? What are your clients are trying to solve for? If you’re 70% invested in equities, is that an adequate depiction of how to meet your clients’ needs? I don’t think so, because of the capital markets environment we’re in today.”

Capone advised that plan sponsors look at how plans and target-date funds are allocated. “It’s all traditional investing: median levels of target dates are allocated in equities alone. It’s more style box investing in disguise,” Capone said. “Considering the returns and performance, it’s not the appropriate path to stay on.”

The point is not just maximizing returns for DC plans, Capone said. Plan sponsors need to be aware of lower long-term expected returns, heightened volatility, rising inflation and the potential for negative returns on fixed income.

“The environment is changing,” Capone said. Market conditions will make it all the more important to diversify, looking at other strategies that have non-correlated structures. Generating stability of return and possibility some income within investments in DC plans are other factors to consider.

In an attempt to find some harmony between the two types of investing and borrow some DB ideas, Capone said they devised different scenarios with a 20% allocation to a nontraditional strategy, each addressing a specific risk factor or investment goal. Real assets were intended to improve sensitivity to changes in inflation. A 20% allocation to total emerging markets included equity as well as debt, in order to provide access to higher growth and a more balanced approach with less volatility to emerging markets investing. 

Stay Liquid for Non-Correlated Returns

“Third, we took a broad definition of liquid alternatives, which can mean a lot of things,” Capone said. This mix was intended to provide a more diversified source of non-correlated returns. “We took down U.S. equities and U.S. fixed income to lower than 60%,” Capone said, and in the simulated performances over a 20-year period, the addition of these non-traditional exposures increased returns over the average DC plan in all cases.

Achieving this allocation and improving returns is not simple or easy, Capone said. “Especially when you consider that DC plans are not professionally managed—they’re managed by plan participants.”

Since the plan sponsor is also looking to simplify, the best way is to designate a bucket within the target date and place these strategies as a sleeve or component in that fund. “The easiest way is to put it in as a percentage of a QDIA (qualified default investment alternative),” Capone said. “Offering them as standalone options in a plan is very challenging.”

People who were heavily allocated toward equities did poorly in the financial crisis, Capone said.  If a plan sponsor or adviser wants to boil it down to three simple ideas, he said, “It all comes down to diversification and what it means,” he said. “How to diversify to get a better risk profile. Reduce home bias, reduce equity bias and look at alternatives.”