Protecting Retirement Plan Returns from the March of Progress

June 4, 2014 (PLANSPONSOR.com) - As with various other major Western economies, the United States has in recent decades seen its retirement plan landscape shift away from defined benefit (DB) to defined contribution (DC) plans.
By PS

In 1980 there were approximately 250,000 qualified DB pension plans in the United States covered by the Pension Benefit Guaranty Corporation. By 2005 there were less than 80,000 remaining. Meanwhile DC plans have been steadily taking their place. Within the U.S., DC plans now account for the majority of assets in private sector occupational pension plans, and research from McKinsey indicates the private DC market will reach $7.5 to 8.5 trillion in assets by 2015, three times the amount within the private DB market.

The rise of the multi-managed fund

The effective result of this transition is that individual savings accounts, originally intended to supplement DB plans, have ended up supplanting them.  This has rendered the question of optimizing returns from investments a cornerstone of the retirement plan debate, as these returns now directly dictate an employees’ eventual retirement income.

This in turn has been a factor behind the rise of the multi-managed fund model. The shift to DC has fragmented the retirement savings market, which alongside increased demand has led to an influx of service providers across the value chain. In combination with increasingly difficult market conditions, this has made the hunt for yield ever-more-difficult for funds. Funds are having to go further afield to generate the returns their investors need.  It is now the norm for pension funds to ‘farm out’ their portfolios to a zoo of specialist ‘best of breed’ sub-funds in order to achieve their participants’ objectives.

The accounting problem

For all the benefits of the multi-managed approach, it has also created a problem. These various sub-funds and service providers inevitably operate under (sometimes subtly) different accounting systems and business processes. In most cases they will all be simultaneously ‘correct’ (or at least not incorrect) but they will nevertheless produce outcomes that differ in small, yet material, ways. The result has been a dramatic increase in the complexity of accounting for funds, accompanied by a greater need for more frequent valuation and reporting.

The potential negative consequences are considerable. Failing to independently consolidate the information according to a single standard will inevitably lead to an accumulation of errors and inconsistencies that will eventually snowball and hit returns. On the other hand an inefficient solution—such as attempting to perform the appropriate reconciliation with old, manual processes—can cause a fund’s administrative burden to balloon. This can in turn needlessly drive up costs, further eating into retirement plan participant returns and harming the funds’ own commercial edge via higher performance fees.

The latter issue of costs is a major one. High costs can have a very significant effect on retirement income. For example, a regular saver who reduces the annual charges on his retirement account from 2.5% of assets to 0.5% would receive a 60% greater benefit at retirement after 40 years.

Yet in the brave new world of defined contribution, it is crucial that plan participants are able to reliably determine the value of their account on a regular basis. This need is only being exacerbated by a global regulatory trend towards increased transparency and oversight. Whether Dodd-Frank in the U.S., Foreign Account Tax Compliance Act (FATCA) across the globe, or Alternative Investment Fund Managers Directive (AIFMD) in Europe,  all require much more robust monitoring and regular reporting as a matter of basic compliance. So how can retirement plans ensure they meet this need without paying too high a price in terms of increased costs and fees?

The solution

What is required is the consistent application of a single accounting approach to underpin accurate portfolio valuations. The answer to achieving this, as with many things in our modern world, lies partly with technology and automation—namely the adoption of a master accounting system at the level of the retirement plan.

Adopting a master accounting system entails taking on portfolio positions at inception date and thereafter processing transactions in parallel with the underlying fund manager systems. This results in a single consolidated current record with comprehensive fund accounting for all portfolios in a multi-managed fund. It ensures consistency and independence of instrument pricing, corporate actions processing, and accounting treatment. Daily accrual of income and expenses supports unitization, and hard valuations of all portfolios enable daily transacting and reporting (or any other frequency as required). The resultant data can be used to monitor compliance, risk and performance at the level of individual investment managers and to ensure that the aggregate portfolio remains aligned with broader investment objectives. Additional monitoring and reporting solutions can be added on top to further facilitate and automate these activities.

A further benefit is that the master accounting approach results in an effective segregation of the key activities of investment management and fund accounting, reconciling portfolio positions to the records of the asset custodian on a daily basis. Master accounting solutions typically provide a comprehensive range of scheduled reports on a regular basis—the availability of a single consolidated record across the fund facilitates the preparation of annual financial statements, resulting in significant reductions on audit fees.

The shift to defined contribution plans and the multi-manager model both represent a step forward—the creation of a more sustainable, efficient system for ensuring that retirement plan participants are able to generate sufficient income for their retirement years. Yet, unless these changes are met with a more sophisticated, automated approach to accounting, retirement plan returns will ultimately be short-changed by the march of progress.

 

Canover Watson, head of Business Development at Admiral Administration

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.

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