The evolution of defined contribution (DC) plans as a primary – and, for many younger employees, the sole – retirement vehicle raises a number of important considerations for plan sponsors. Specifically, plan sponsors must actively manage the transition from a defined benefit (DB) plan as the centerpiece of employer-provided retirement income and give careful thought to a host of issues, from plan design features to the investment options and education and communication programs offered to DC plan participants.
Point of View recently spoke with Ashish Gandhi, product manager in the Defined Contribution Solutions Group at Northern Trust, about the evolving role of DC plans and the implications for plan sponsors.
Point of View: The pendulum has swung in favor of DC plans as the primary employer-provided retirement vehicle in the United States. What are the factors driving this shift?
Ashish Gandhi: According to the U.S. Department of Labor, there are currently more active participants in DC plans than DB plans in the United States, but the shift toward DC plans is also evident internationally. In Towers Watson’s 2011 Global Pension Asset Study in which the authors examined the world’s 13 major pension markets, you see that DC assets have grown at a rate of 7.5% annually while DB assets have grown only 2.9% annually during the past 10 years.
There are several reasons for this trend, including the rising costs associated with administering DB plans and market volatility, which can lead to inconsistent funding obligations. Coming out of the market downturn of 2008, many sponsors were forced to make very large contributions to their DB plans to meet funding requirements. In some cases, this unforeseen cash flow led to the suspension of employer matches in DC plans and other benefits. Changes in mortality also have implications for an already sensitive asset/liability equation. To put things into perspective, U.S. Census Bureau data show that one in every 5,900 Americans was projected to live to the age of 100. The combination of these factors has prompted many plan sponsors to reconsider the merits of continuing to offer a DB plan. In some cases, plan sponsors have closed plans to new participants or have frozen benefit accruals. In other instances, some plan sponsors have embarked on a journey toward the eventual termination of their DB plans.
Point of View: What should plan sponsors consider if moving from a DB to a DC plan as the primary retirement vehicle?
Ashish Gandhi: First and foremost is retirement readiness – how they can help their employees prepare for retirement, especially younger employees who might never be part of a DB plan. Among the greatest challenges is designing the optimal investment lineup to meet the needs of a bifurcated workforce. A DC plan may serve as a supplement for some, but as a primary retirement vehicle for others. A key aspect to consider will be how many asset classes and the number of investment options to offer along the risk-return spectrum. Once the investment construct has been determined, thoughtful consideration should be given to crafting a robust communication and education program. A carefully constructed program will play an important role in changing the mindset of employees, who will now carry a greater responsibility in preparing for retirement. Plan sponsors also will need to change their focus in terms of benchmarking plan success. Plan participation has been used as a measuring stick; however, going forward the focus will need to shift to quality of participation and income sufficiency at retirement.
Point of View: What are the key factors for a retirement program?
Ashish Gandhi: Among the key factors for any successful retirement program is sufficient funding. Some would argue funding, or savings in the context of a DC plan, is even more critical to positive outcomes than asset allocation. In a DB plan, the plan sponsor bears the entire funding burden, but within a DC environment the responsibility shifts almost entirely to the employee.
Therefore, one of the goals for the plan sponsor should be to encourage participants to start saving early and adequately. The use of automatic features can help address this need. Following the enactment of the Pension Protection Act of 2006 (PPA) in the United States, auto enrollment has become one of the more prominent features adopted by DC plans, helping increase plan participation rates vastly. However, the adoption of auto escalation has been much slower, and, as a result, people still are not saving adequately because of the lower default contribution rates used at the time of enrollment, typically averaging between 3% and 4%. Implementing auto-enrollment at a higher initial contribution rate that ensures employees receive 100% of employer matching contributions and gradually increasing deferrals via auto-escalation over time to a meaningful level near 15% would significantly increase the probability of achieving retirement goals.
Point of View: From a structural perspective, what features should the DC plan incorporate?
Ashish Gandhi: In addition to funding, there are also investment considerations. When most plan sponsors think about auto features, they think of auto enrollment, auto escalation and auto rebalancing, but target date funds (TDFs) are another type of auto feature. TDFs provide automatic diversification, as a participant’s asset allocation is automatically adjusted to match his or her risk tolerance over their retirement time horizon. Professionally managed portfolios such as TDFs can greatly improve retirement outcomes as they are typically constructed on a more efficient basis and feature a mix of asset classes beyond stocks, bonds and cash. A study published by AonHewitt and Financial Engines in September 2011 found that participants using “help” features (target retirement date funds, managed accounts and investment advice) fared better than their non-help counterparts. Help-participants, on average, experienced returns nearly 3% higher than non-help participants, net of fees. The two primary reasons cited behind the poor portfolio performance of non-help participants were inappropriate risk levels and inefficient portfolios. Portfolios of participants not using help tend to have higher levels of risk, as measured by standard deviation, and are often inappropriately diversified.
All of these auto features go hand in hand. In fact, in April 2011 Northern Trust completed a study demonstrating that coupling auto-enrollment and auto-escalation with a target retirement date fund can improve vastly retirement savings outcomes. (For information about the Northern Trust study, contact DC_Solutions@ntrs.com.)
Point of View: While we’re on the topic of investments, what else do plan sponsors need to think about in terms of the investment menu they provide?
Ashish Gandhi: When it comes to the investment options offered, the approach should be “less is more.” As a society we embrace choice, and the initial premise of a DC plan is providing individuals the choice to determine how his or her assets are invested. However, too much choice can serve as an impediment to decision making and cause inertia. Plan sponsors should craft a streamlined investment menu that provides sufficient diversification opportunities and addresses the needs of the most- to least-engaged participants. An edited menu also might enable plan sponsors to achieve greater scale with higher quality managers, enabling participants to enjoy lower investment management fees, which will have a meaningful impact on retirement savings.
Point of View: Given that plan participants ultimately bear the responsibility of saving adequately and allocating their assets, what else can plan sponsors do to help ensure participants make sound decisions?
Ashish Gandhi: As we strive to improve financial literacy in the United States, it is critical that plan sponsors implement a robust education and communication program to help participants prepare for retirement. DC plans in general have created a number of unintended investors, forcing participants to make investment decisions that they have not been trained to make. In managing a DB plan, the help of professionals such as actuaries, consultants and investment managers is commonly used to determine the appropriate asset allocation and funding. However, in a DC plan, the participant is left to take on the role assumed by these professionals. Participants should be educated on key concepts related to sufficient savings, asset allocation, diversification and the role of various asset classes.
Point of View: Do you see a place for annuities in DC plans?
Ashish Gandhi: As DC plans continue to look more and more like DB plans, addressing both sides of the retirement income equation – accumulation and “decumulation” – makes sense. In what can be referred to as the “automatic era” in DC plans, participants are commonly automatically enrolled into a plan, defaulted into an automatically diversified portfolio and, in some plans, their deferrals are automatically escalated. However, upon entering retirement, they receive their account balance in a lump sum and are tasked with the duty of maintaining a comparable lifestyle and positive account balance. Research on investor behavior generally shows that individuals have difficulty managing retirement payouts on their own, and a lifetime income vehicle would certainly aid in this task. Although there has been great progress on product development in the industry, plan sponsors have been slow to adopt these income solutions. The major concerns continue to be cost, counter-party risk, portability and participant education. In-plan annuity based solutions may not see tremendous uptake until plan sponsors receive some regulatory relief, much like the Qualified Default Investment Alternative regulations that granted a safe-harbor relief for TDFs, balanced funds or managed accounts upon automatic enrollment.
As DC plans evolve as the primary workplace retirement vehicles, it is essential plan sponsors think strategically about all aspects of their retirement program. Many of the concepts learned in managing DB plans can be utilized to transform DC plans to address both sides of the retirement equation, pre- and post-retirement. Ultimately, the success of the DC plan is not measured by participation rates, but rather by the quality of participation and retirement outcomes. Define the challenges of your workforce and design the savings and investment program to serve as a solution.