As defined benefit (DB) plans continue to be frozen or terminated, a greater number of American workers will rely on defined contribution (DC) plans to provide for their retirement. Estimates of the U.S. retirement market indicate that with a projected market value of more than $8.5 trillion in 2018, DC plans will be larger than their DB equivalents by $1.3 trillion.1 Even with the growing number of workers covered through such plans, however, there is mounting evidence suggesting that DC plan participants are not on track to sufficiently fund their goals.2
For insight, BNY Mellon sponsored research that involved in-depth interviews with 20 of the leading Fortune 500 DC plan sponsors in the U.S., including leaders and innovators in technology, manufacturing, healthcare and other sectors. They represent organizations with billions — or even tens of billions — in DC assets; many have even larger DB plans. As such, their complexity and buying power provide the need and the wherewithal to fuel innovation and cost savings, and to better ensure favorable retirement outcomes.
The interviews provided insight as to how these organizations are responding to the evolutionary change underway, and what best practices are being utilized to increase the efficiency of their plans.
Three Common Themes Emerged:
- The “Institutionalization” of DC Plans
- Education and Automation Working Together
- Unbundling and Transparency: Shining a Light on Fees
THE "INSTITUTIONALIZATION"OF DC PLANS
Since the introduction of the first private pension plan in 1875, pensions have evolved into a highly sophisticated institutional industry. With the need to meet pension obligations, DB plans and their sponsors have looked at many different ways to achieve these objectives (e.g., leveraging broad asset allocation and investment structures and other techniques). While acknowledging that maintaining DB plans was either too expensive or too burdensome, many of the interviewed sponsors wanted to be able to replicate some of the efficiencies they utilized when running DB plans. Comparing the DB experience to the more typical approach on the DC side, a number of shortcomings are often identified with DC plans:
- Higher costs
- Limited access to alternative investments, limiting their potential to increase returns and reduce risk through diversification
- Uncertain financial benefit with participants bearing investment risk
Plan sponsors have sought to address the limitations of DC plans by borrowing best practices from the DB arena. While stopping short of a full-scale return to the pension model, the so-called “institutionalization” of DC plans relies on the following approaches.
Increased Use of Low-Fee,
When seeking to make their DC plans more DB-like, the use of institutional vehicles provides plan sponsors with low-hanging fruit. Mega market sponsors interviewed, defined as plan sponsors with at least $1 billion in DC assets, expect a 65% increase in their use of alternatives to mutual fund vehicles, such as separately managed accounts (SMAs) or collective investment trusts (CITs).
Costs or fee advantages can offer a clear benefit of SMAs and CITs over the mutual fund investment approach. Since these vehicles are not subject to oversight from the U.S. Securities and Exchange Commission (SEC), they do not incur some of the expenses associated with compliance and regulatory reporting.3,4 In addition, there is also no need to support the marketing and distribution of the fund into the retail space (e.g., producing prospectuses and retail call centers). Further, retirement participants are more typically “buy and hold” type investors, reducing portfolio trading costs. This can all result in both lower initial and ongoing operational costs.
Alongside the rise in use of CITs and SMAs, sponsors are reducing their reliance on off-the- shelf mutual funds. With billions or even tens of billions in assets, sponsors of mega-plans have both the need and the ability to demand custom solutions. A number of sponsors in the study are assembling white-labeled options in an effort to simplify their investment offering and reduce fees. Plan sponsors see this as offering the best of both worlds: improving underlying diversification while minimizing participant confusion by limiting the number of investment options.
Greater Use of Alternative Strategies
In addition to lower-cost vehicles, DC plan sponsors are also looking to increase their use of alternative strategies. Large plan sponsors witness firsthand what studies have shown: their DB plan investments typically outperform their DC offerings, sometimes by as much as two percentage points per year.5,6 Providing access to asset classes that participants did not previously have may allow them to get closer to the level of returns for DB plans and also to embrace other characteristics of alternative investments such as downside or inflation protection.
Many sponsors have overcome the operational challenges and are delivering a true institutional investment platform. One approach is to use more liquid strategies, sometimes in the form of ’40-Act registered mutual funds which strike net asset values (NAVs) and meet redemptions on a daily basis. Sponsors interviewed are also looking to include alternatives within multi-asset portfolios, such as a target date fund (TDF). Doing so provides improved liquidity, while allowing participants to potentially realize the benefits of diversification.
Generating an Income Stream
Taking an institutional approach to investing may improve results, but any serious discussion of “institutionalization” must consider lifetime income. When asked to identify the greatest driver of DC change over the next five years, 55% of plan sponsors cited the need to address longevity risk by generating retirement income.
Whereas actuarial formulas provide clarity for DB participants, it is hard to get DC participants fully engaged when there is uncertainty not only about the amount of asset accumulation (a function of market performance, contribution rate, etc.) from retirement savings, but also how that will translate into retirement income.
In the same way that people know the monthly payments of their pension (DB) and social security, the same thing can be done with DC plans. Improved reporting and retirement income calculators are more prevalent to help educate the workforce. Moving beyond this to implementing a retirement income strategy is an area where forward-thinking plan sponsors are taking action. They are engaging with their plan’s advisors/consultants, insurers and other providers to formulate ways to provide participants with sufficient retirement income.
EDUCATION AND AUTOMATION WORKING TOGETHER
Given the emphasis that DC plans place on individuals — the majority of whom have little or no investment knowledge — how best to engage the workforce to plan for retirement has long been a focus for HR and other plan professionals. While automation has proven to be a scalable solution for engaging most participants, it has not ensured adequate savings rates, it does not address participants’ unique circumstances, and it fails to provide a post-retirement roadmap. To address these limitations, plan sponsors are combining automation with focused education.
The Need for Increased Savings
While auto-enrollment has increased participation rates, many participants are not on track to meet their goals. Automatic enrollment is often implemented with new employees only, stopping short of full-scale re-enrollment of all employees, which some sponsors view as opening them up to increased liability. More importantly, default rates under auto-enrollment tend to correspond with the company match threshold — often between 3% and 6% — despite the fact that many experts recommend a target of 10% or higher. For many employees, there is still a disconnect between their projected retirement savings, income and needs, and their behaviors such as taking loans and reducing contributions that only compound the risk of falling short. When asked how their time allocation will change, 63% of plan sponsors say that they expect to spend more time on participant education.
Meeting Demographic Challenges
Education remains relevant given the wide disparity in participant demographics. Even at similar income levels, participants of varying ages and tenure face different risks.
Retirement’s New Beginning
Plan sponsors also cite the need for education that targets retiring employees. Particularly for participants in mega-market plans with significant buying power, rolling out of the plan at retirement often means shifting into higher-priced products that will eat into participants’ retirement income. Often, the TDFs or stand-alone investment options in the DC plan will not be available in a retail setting. The need for retirees to revisit their asset allocation and develop a decumulation strategy may necessitate hiring an advisor, which will incur additional fees. Communications targeted at participants nearing retirement can highlight the fact that staying in the plan is a compelling option. In addition, it could potentially stave off large asset rollovers out of the plan, which could lead to decreased economies of scale and higher fees for remaining participants.
UNBUNDLING AND TRANSPARENCY: SHINING A LIGHT OF FEES
Although they have come a long way from being wholly reliant on proprietary fund lineups, DC pricing models continue to evolve. Bundled pricing arrangements — whereby investment management, recordkeeping and potentially other administrative fees are all included together — can potentially limit transparency, inflate costs and introduce conflicts of interest. Plan sponsors are increasingly looking to overcome these challenges through unbundled pricing models and adopting buying behaviors just as they would in the DB world.
The DC plan of the future will have a more transparent fee structure, particularly on the investment side. The vast majority (95%) of mega-market sponsors expect to see greater unbundling with less reliance on revenue sharing. Whether driven by regulators, lawsuits or voluntary changes, sponsors anticipate a decreased reliance on marketing and distribution fees (e.g.,12(b)-1 fees) and related payments. Fees will become more competitive once sponsors can see what they are paying for.
Reducing Conflicts of Interest
Beyond their desire to negotiate fair fees at the plan level, plan sponsors are concerned that the activities of certain participants are being subsidized by others. When the cost of these services is not itemized, but rolled into the total cost of the plan, a conflict of interest is created. Accordingly, almost one-third (30%) of surveyed plan sponsors expect to see some increase in per-use service fees charged to the participant. Implementing this type of fee structure requires insight from service providers such as recordkeepers and an in-house consensus on who pays for what. This analysis may be straightforward when user fees are already in place, but may require additional work if such charges were previously eschewed in favor of the “all-in” bundled fee arrangements common in the DC space.
Lowering Overall Costs
Plan sponsors see increased transparency not only as a goal in itself, but also as a means to an end. The majority of those surveyed believe that unbundling will continue to bring down fees: with clear segregation in investment costs and recordkeeping costs, sponsors will be able to comparison shop and negotiate a better deal with their providers.
KEEPING PACE WITH THE DC EVOLUTION
Taking a page from several forward-thinking organizations that were interviewed, plan sponsors — in conjunction with their advisors/ consultants and ERISA attorney — should ask themselves the following questions:
- Have the plan’s investment options been assessed in the past 12 months?
- Is the plan sponsor confident that plan participants have the right tools to prepare them for retirement?
- Does the plan sponsor actively manage costs within the DC plan?
In order to stay ahead of the curve, the chart at left provides plan sponsors with a roadmap for suggested actions.
This article is a recap of BNY Mellon Asset Servicing team's white paper, The DC Plan of the Future: DB Principles for the DC Generation. Read the full article.