Plan sponsors should consider individuals’ savings and investment patterns with plan design to help participants achieve a successful outcome at retirement.
Defined contribution plan participants can be their own worst enemy because of mistakes that are inherent to human nature. Emotions, confusion and being overwhelmed by an excess of information — including too many investment choices — clouds thinking and affects rational behavior. Individuals can trip themselves up in many ways — not saving enough, ignoring the benefits of tax-deferred savings, and investing too conservatively or aggressively.
After trillions of dollars were lost in the brutal 2008 market downturn, the spotlight is shining brightly on the inadequacy of the typical employee’s retirement savings. That is particularly true for those whose retirement relies entirely on their participation in a defined contribution (DC) plan. In many cases, poor or inappropriate asset allocation decisions by participants led to larger losses than would have been incurred in more broadly diversified, optimized portfolios. A study by Hewitt Associates found the average 401(k) balance fell from $79,600 in 2007 to $57,200 at the end of 2008. Further, for those 401(k) participants nearing retirement, the Employee Benefit Research Institute found that in 2006, about 38% of these investors had 80% or greater invested in stocks. The average account balance for these near-retirees had fallen more than 20% for the 12-month period ending March 2009.
James Danaher is Senior Investment Product Manager at Northern Trust. He has more than 15 years experience in providing guidance to plan sponsors for their defined contribution investment and administrative programs.
Plan sponsors can help participants by understanding the field of behavioral finance and designing their DC plans in ways that help simplify and minimize the touch points in the participants’ decision-making process.
Mercer’s May 2009 “DC Quick Survey” found that 68% of the 180 organizations responding felt that they share responsibility with employees to provide retirement benefits. When considering plan participation quality, there are a number of common mistakes that DC participants tend to make, which lead to negative outcomes. Plan sponsors can help them achieve better results by being more cognizant of these pitfalls.
The impact of all these mistakes adds up. Typical outcomes are poor diversification, asset allocation that is overly aggressive or conservative, and insufficient retirement savings.
According to a 2008 comprehensive study of nearly 1 million 401(k) participant portfolios by Financial Engines, 69% of all participants have portfolios that are inefficient or have inappropriate risk levels. Making matters worse, those earning the lowest salaries are most likely to have inappropriate asset allocations.
Similarly, participants earning the lowest salaries and those closest to retirement are more likely to have too high a concentration in employer stock. More than half of all participants earning less than $25,000 held more than 20% of their portfolio in company stock. Moreover, one in four participants over age 60 had 50% or more of their portfolio in employer stock.
In addition, even an appropriate asset allocation that is properly weighted can get off track.
There are ways to help DC plan participants avoid mistakes, improve savings rates and potentially achieve better investment results. Four of the most effective methods are automatic enrollment, automatic increases in savings rates, rebalancing portfolio allocation to original investment elections and automatic default into professionally managed vehicles, such as target date retirement funds.
The evidence in favor of automatic enrollment is overwhelmingly positive. A study by the Vanguard Center for Retirement Research found the participation rate among new hires rose to 86% from 45% after introducing automatic enrollment. But simply enrolling participants without automatically increasing their savings rates will likely back-fire because of inertia. Ideally, the incremental increase of participants’ contribution rates every year is the single best chance they have of reaching retirement savings goals.
From accumulation in the savings years to capital preservation in the spend-down years, target asset allocation vehicles can address the dual concerns of initial asset allocation and automatic rebalancing throughout the participant investment lifecycle.
Target asset allocation vehicles, whether they are based on tolerance for risk or year of retirement, can be a good solution for meeting the needs of a majority of DC plan participants. Moreover, target date retirement funds effectively integrate a defined benefit plan investment philosophy into a DC investment choice. A well-diversified portfolio combines a robust asset allocation with a systematically rebalanced glidepath to meet the funding liability at retirement.
Target date retirement funds are likely best constructed with four primary asset categories: equities, fixed income, an inflation-hedge component and short-term cash investments. Each category should contain multiple asset classes, such as domestic and international stocks (with exposure to developed and emerging markets), TIPS, commodities, global real estate and high-yield bonds. The minimization of risk is enhanced due to the typically lower levels of correlation between these asset classes.
As a qualified default investment alternative, a target date fund is an effective and cost efficient way to integrate initial asset allocation and rebalancing back to targets defined by a retirement date-based strategy. They can incorporate a broader, more sophisticated investment mix, including alternatives that tend to have low correlation with the major asset classes.
There are some troubling misconceptions about target date funds that have recently surfaced. A survey conducted by Envestnet Asset Management and Behavioral Research Associates earlier this year indicated that close to 62% of respondents believed they would be able to retire at a fund’s target date; almost 38% believed target date funds offered a guaranteed return; more than one-third believed their savings would grow faster; and most alarming, almost 30% thought they would not need to save as much.
In addition, contrary to what some plan sponsors might have thought, not all target date asset allocation philosophies are similar. One issue made clear in the recent bear market is the variance in manager glidepaths. Although it is universal that the most aggressive asset allocation will be held in the longer-dated funds, the percentages to which managers allocate to higher risk asset classes, like equities, can vary widely. More importantly, as glidepaths roll down toward their target dates, key differences among managers tend to emerge, particularly among the 2020-2025, 2010-2015 and income glidepath points. Often, while appropriate from an investment thesis standpoint, participants were exposed to higher levels of risk than either they or their plan sponsors realized.
The most distinguishing factor in target date fund management is the glidepath. How much risk does a manager believe is appropriate? Does the glidepath provide management to retirement (typically age 65) or through retirement (sometimes referred to as “target death”)? Plan sponsors need to research the slope of a manager’s glidepath, understand the implications based on the level of risk assumed by participants, confirm how the manager defines a successful financial outcome at retirement and what quantifiable methods have been used to validate the probability of success.
Sponsors that follow a prudent due diligence process in plan design, combined with effective education communicated in a strategic manner, may influence participant behavior, thus enabling them to save and invest for a more financially secure retirement.
Future plan design considerations suggest that sponsors may also need to focus on a guaranteed lifetime income component. Because DC plans — predominantly 401(k)s — are fast becoming the primary work-based retirement vehicle, there is acknowledgment that in their present form, most Americans will not be able to solely rely on their DC plan balances for a financially secure retirement. In the next issue of Point of View, DC Solutions Group member Susan Czochara will write about one of the next frontiers that DC plan sponsors may need to address: Retirement Income Solutions.