2012 Issue 3
By leveraging the best defined benefit plan approaches, defined contribution plan sponsors can help improve participants’ retirement savings outcomes.
Defined contribution (DC) plans increasingly serve as the primary retirement savings vehicle for most Americans — in many cases, replacing or augmenting defined benefit (DB) plans. As a result, much of the investment risk has shifted from employers to employees. What does this mean to a workforce that is living longer, saving less and facing less-reliable governmental support than past generations?
In this uncertain environment, DC plan participants need a more robust framework with which to invest for their future. Fortunately, much of that framework already exists within the world of DB plans. For plan sponsors, the challenge is how to overcome technical barriers and internal roadblocks to bring the institutional investment and organizational expertise of DB pension plans to the DC universe.
The 2012 installment of Northern Trust’s “The Path Forward” DC research series identified five winning strategies that DC plan sponsors can leverage from DB plans:
Applying the best of DB practices to the world of DC, or “institutionalizing” DC plans, is one way DC plans are embracing a more disciplined and professional approach to focusing on improved retirement outcomes for participants. This shift in thinking has been sparked by the growth in DC plan assets, which, according to the 2012 Towers Watson Global Pension Asset Study, now represent 57% of U.S. pension assets.
For example, DC plan sponsors should identify ways to incorporate broader opportunities for diversification without inundating participants with more investment options.
Scientists studying investor behavior have found that when investors are faced with too many choices, they can become overwhelmed. That may lead to inaction; arbitrary decisions, such as allocating the same amount to every possible investment choice; or making some other type of hasty or illogical decision. Offering participants fewer choices — but enough to cover the risk/ reward spectrum of asset classes — tends to lead to better asset allocation. The 2012 Path Forward survey found 89% of consultants recommended that plan sponsors offer 11 to 15 investment options in their DC plans. In contrast, almost half (46%) of the plan sponsors surveyed currently offer more; that is, 16 to 25 options.
The use of professionally managed, multi-asset class products, such as target date funds or target risk funds, has coincided with an increase in participation levels. They can also lead to enhanced results by leaving investment decisions, such as asset allocation and rebalancing, in the hands of professional investment managers.
“Target date funds also provide an efficient, effective way to include alternative asset classes in a DC investment menu,” said Jim Danaher, managing director of Northern Trust’s DC solutions group. He noted that while alternatives, such as commodities and real estate, can be offered as stand-alone menu options, integrating them within a single professionally managed solution protects plan participants from inappropriate allocations to these more volatile assets.
“When you combine the use of target date funds as a default investment option with features like automatic enrollment and automatic contribution escalation, you provide participants with an investment experience that in many ways resembles that of a traditional, professionally managed DB pension fund,” Danaher said.
With DC plan assets accounting for more than half of U.S. pension assets, investment committees need to recognize the heightened importance of DC plans, relative to DB plans. Accordingly, they must devote sufficient attention, resources and professional rigor to DC plan design, manager selection and the monitoring of manager performance.
The 2012 Path Forward research also revealed that DC plan sponsor decision-making processes must be more streamlined with clearer authority. Sponsors need to be mindful of their fiduciary role, embracing it as they provide participants with investment options, tools and advice.
DC plan sponsors have not taken full advantage of opportunities to manage fees with optimal efficiency, particularly given the scale and attendant opportunities. One potentially outdated and counterproductive practice is revenue sharing agreements between sponsors and investment managers, which can conflict with the best interests of DC participants.
Lower fees can also be achieved through greater use of passive strategies in a plan’s core fund lineup, as well as through the use of target date funds. Benchmarking investment management fees in DC plans with those paid by the same plan sponsor in DB plans could also raise awareness and potentially lead to renegotiating lower fees in some cases. Danaher noted more cost-efficient vehicles, including institutional rather than retail mutual funds and collective investment trusts (CITs), can make a wide-scale difference. “Plan sponsors can also reduce fees by leveraging the same managers and investment styles for assets managed for DB and DC plans in the same organization,” he said.
When it comes to the distribution of one’s retirement benefit, there’s been a tremendous difference between the typical approaches of DB and DC plan sponsors. The DB approach is focused on a life-long payment stream. DC plan sponsors, however, often have taken a hands-off, neutral or indifferent stance on what participants do with their savings after they retire.
DC plans are continuing to grow in importance. There is no question that they are vital to the financial well-being of plan participants.
Aside from the inherent focus on outcomes or benefits in the DB framework, there are a number of clear advantages to retaining investments in a DC plan after participants retire. For example, access to institutional pricing can leave retirees with a higher net accumulation to help better support the rate of withdrawal during the decumulation phase, Danaher said.
“Plan sponsors can save money by leveraging the same managers and investment styles for assets managed for DB and DC plans in the same organization.”
— Jim Danaher, managing director, DC solutions group, Northern Trust
“One major danger to avoid is the lump-sum payout, which is fraught with the risk individuals will mismanage their money,” he said.
The traditional DC plan focus on accumulation of assets — rather than decumulation — has led to a lack of emphasis and involvement by plan sponsors in providing guidance or a better framework for responsible withdrawal of retirement assets by DC participants.
“The keys to success include better retirement income planning tools, education and advice at the point of retirement and beyond, plus investments that are designed for asset preservation and payout options that match the income needs of participants,” Danaher said.
An important aspect of institutionalizing DC communications is a focus on eventual outcomes rather than recent investment performance or current asset valuations. Although DC plans, by nature, are focused initially on contributions, it is the outcome at retirement that ultimately matters.
Although DC plans, by nature, are focused initially on contributions, it is the outcome at retirement that ultimately matters.
One important aspect is to demonstrate how an increase in the contribution rate during the course of a participant’s career could affect the post-retirement monthly payments an individual receives, and to compare that to the benefits their current savings would produce. That would underscore the long-term impact of the participant’s actions.
“To be most effective, communications should be done regularly, harness the power of technology and provide a personal touch,” Danaher said. “Regular communications to current employees and retirees are essential for delivering and reinforcing core messages about the importance of investing for retirement.”
Danaher added that customizing communications to the needs of various age groups will make them more relevant, and in-person meetings, including group and one-on-one sessions, can enhance the effectiveness of communications as well. DC plans are continuing to grow in importance. There is no question that they are vital to the financial well-being of plan participants. By applying best practices from DB plans to DC plans, plan sponsors can go a long way to meeting their fiduciary obligations to help plan participants prepare for a more secure retirement.