The defined contribution (DC) retirement plan industry continues to innovate to remold and reshape plans to create real retirement security for participants.
As more responsibility has shifted to participants for managing their own retirement savings, it has become obvious that they are not as equipped to do so as those responsible for the management of defined benefit (DB), or pension, plans. So features of DC plans have evolved to mimic those of DB plans.
Mike Swann, client portfolio manager at SEI in Oaks, Pennsylvania, says the fact that each participant is responsible for his own outcome is one of the things that is not working in the DC retirement plan system. Participants are not familiar with how to set up portfolios to withstand market losses or how to react to market losses, and they are subject to their own whims—taking hardship withdrawals or loans and reducing or stopping contributions when they need cash.
While DC plan design has undergone many changes over the past few decades, one thing that hasn’t changed is the behavior inherent in the majority of people, says Gregory Kasten, MD, CFP, AIFA, founder and CEO of Unified Trust Company based in Lexington, Kentucky. There are five financial behaviors that don’t change that have been well-documented for more than a decade by UCLA professor Shlomo Benartzi along with Richard Thaler of the University of Chicago, Kasten says: inertia, procrastination, choice overload, endorsement and framing.
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“Inertia tells us that however a participant is started is how they go. So, if we start them wrong, they generally will not correct, but if we start them right, they tend to stay on the path,” he explains. “Procrastination tells us that we can put in front of someone a reasonable pathway, but if they have to do everything themselves, they will put off doing it. Choice overload is when a participant is given too many choices, he shuts down and makes the simplest choice, which is no choice. Endorsement is when participants think whatever is put in front of them must be right because the [employer/plan provider/plan adviser] wouldn’t put in front of me something that is wrong. And framing is when a certain answer is provided depending on how something is asked.”
Kasten notes that the industry has tried to create tools and calculators in the hopes that participants may be coached out of the five behaviors, but there is very little use of these tools, at about 10% of participants. “The answer is we have to do almost everything for participants. That’s why automatic plan features are working,” he says.
“The effect of wide adoption of auto-features is participants have deemed that is what they should do,” Swann says. “Especially when a plan sponsor automatically re-enrolls employees into a QDIA [qualified default investment alternative], it tells people, ‘This is the right answer and you need to stick with it.’”
Ross Bremen, a partner in NEPC’s defined contribution practice in Boston, says target-date funds (TDFs) “continue to be the answer for most plan participants,” helping them stay the course during challenging times.
However, Bremen points to another thing that is not working for the DC retirement plan system. While plan sponsors may try to provide the right messaging for participants, they get mixed messages in other ways. Regulators and legislators tend to turn to DC plans to provide financial help for employees in times of disaster or emergencies. Bremen specifically points to the Coronavirus Aid, Relief and Economic Security (CARES) Act passed on March 27. “While it may be providing necessary funds for participants, it may also be creating a savings challenge for those who take distributions or loans,” he says. Such legislation sends a mixed message to participants who are told repeatedly to keep their retirement savings invested for the long term.
Bremen points out that there is mixed messaging even within the legislation. “The legislation says RMDs [required minimum distributions] don’t have to be taken, but it opens up other avenues for participants to take their money. I understand the RMD idea is that participants nearing or in retirement need more time to make up for market damages, but even the government in its own rules is sending confusing messages,” he says.
Bremen adds that plan sponsors should provide communications to participants about how damaging withdrawals and loans could be on their retirement savings and about focusing on the long term. They should also be thoughtful about balancing CARES Act relief and retirement outcomes and consider not offering some or not offering all provisions.
Along Came COVID-19
Despite the mixed messaging, Bremen says he doesn’t think the COVID-19 pandemic has revealed that wholesale changes are necessary to DC plan design, as he points out that most participants are staying the course in saving and investing.
Kasten says, if anything, financial crises such as the one caused by the pandemic re-emphasize the five behaviors that DC plan design has been addressing, as those behaviors may become worse during crises. “We found in the first quarter [of this year], if a plan is set up to do everything for participants, there is no spike in calls to call centers and no spike in people wanting to change investments,” he says.
However, even though wholesale changes might not be necessary, the pandemic has revealed a couple of shortfalls in DC plan design, Kasten says. He notes that a study in February revealed that the average person nearing retirement held 78% of his portfolios in stocks. “Most retirement experts would probably say this is too much for someone a few years from retirement. Sequence risk is bad when returns fall shortly before or just as a participant retires,” he says.
Kasten says the pandemic shined a light on the fact that DC plans do not effectively de-risk those closest to retirement. “We measure risk for each participant and put that on retirement plan statements. It needs to be monitored more, because if you don’t measure something, how can you manage it?” he says.
There need to be some structures—risk constraints—that can keep risk manageable, Kasten adds. He says Unified Trust Company uses two strategies to reduce risk for five to six years up to retirement: Participants’ overall asset allocation is changed to lower exposure to equities than the average TDF and stable value funds in managed accounts are used. “Most TDFs don’t hold stable value funds because they are not mutual funds, but stable value is very helpful when, like in the first quarter, the bond market was also losing money. It has a smoothing effect on fixed income,” Kasten says. He adds that this highlights an issue with TDFs—they only consider a participant’s age and not his goals or whether he’s on track to reach his goals.
Another thing the pandemic has revealed, Bremen says, is that there is still a large focus on investment performance and not on replacing monthly income. “It’s the nature of how DC plans are managed, where we have web-based information and people can look at their balances and trade each day,” he says. “That’s not how a pension plan operates. It focuses on long-term income replacement.”
Swann echoes that idea, saying the “focus on TDF performance exclusively is fairly misguided. It gets distorted during long bull market runs. The focus has to be on downside risk management. People retire every day, and, when a month before they retire, they lose 20% of their balance, it drastically changes their retirement outlook. The lack of focus on downside risk creates meaningful and significant impacts on participants.”
He adds, “Each TDF series has a different approach for mitigating different risks near and after retirement. Plan sponsors can see in the dispersion of returns and results of the first quarter how TDF providers manage risk compared to each other. They have to understand the concentration of risk in the portfolio rather than focus on returns and pure rankings.”
The Next Big Focus
Swann says he believes the next big focus for DC plan design will be evaluating downside risk, especially for those closest to retirement.
He says the Setting Every Community Up for Retirement Enhancement (SECURE) Act will help as it allows plan sponsors to explore guaranteed income products. Even if legislative and regulatory hurdles are cleared, however, the pricing hurdle needs to be cleared, Swann notes. “Current costs with commissions in the multiple hundreds of basis points [bps] create a challenge for getting these products into DC plans,” he says. Though some cost is worth the downside protection, cost will have to continue to be compressed.
But Swann says he believes providers will find a way to make products work in a cost-effective manner. “The evolution of DC plan design will be driven by market demand,” he says. “The ‘give as much risk as participants can take to get market performance’ argument is going to change. Providers tend to innovate to where clients want, but they will have to do that in a way that is price competitive. There’s a chance lifetime income solutions will stay outside of plans, but their buying power would drive costs down.”
Kasten says the next focus for DC plans will be how to take accumulated savings and create a lifetime income stream because the way plan sponsors define success is changing. Traditionally, plan sponsors have measured success by participation rate and participant savings rate, but those are not endpoints. “The endpoint is replacing paychecks when participants retire.” He says he believes guaranteed income strategies, lifetime income strategies and payout strategies—“things that make DC plans look more like pensions”—will be incorporated into plan design.
Bremen says he also believes the income focus will include several elements—different types of fixed income offerings, managed accounts, annuity products and an analysis of how solutions fit into DC plans.
He points out that when plan sponsors build their DC plans, they don’t all choose the same features, and he says the same will be true for retirement income. “Not all retirement income products are the same, and not all participants are the same. The evolution of personalization will continue for retirement income,” Bremen says. “The idea that a single solution works for everyone, which historically has been the case for TDFs, will change to give participants the tools they need to craft a solution that is right for them.”
He adds that work is already being done on income solutions, and it will take time for plan sponsors to become educated about and to evaluate the range of solutions available.
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