© Copyright 2002 Rogers Media. The following article first appeared in the April 2002 edition of BENEFITS CANADA magazine.

The investment climate today is characterized by great uncertainty and caution. There were signs of a global slowdown and possibly a recession prior to Sept. 11. The manufacturing and technology sectors had contracted in Canada and abroad, and at home the gross domestic product declined in each of the first two months of the third quarter of last year. By Sept. 10, 2001, returns for the Toronto Stock Exchange (TSE) 300 and Standard & Poor's (S&P) 500 composite indexes as well as the Morgan Stanley Capital International EAFE index had declined by more than 28% each since their market peaks in 2000.

One positive factor buoying the economy was a high level of consumer confidence and spending. Unfortunately, the events of Sept. 11 and subsequent layoffs in numerous industries eroded much of this edge. In the U.S., the Conference Board's consumer confidence index fell from 114 in August 2001 to 97.6 in September--marking the largest drop in a single month in more than 10 years.

The onset of weaker economic markets raises new challenges for defined contribution (DC) plan sponsors. The majority of members joined these plans during an unprecedented period of sustained market performance in the 1990s and, as a result, many members based their long-term expectations and asset allocation decisions on this favourable environment. Indeed, this is the first taste of a market downturn for many DC participants.

With this in mind, it is important to understand how investors respond to market shocks. Research shows that many investors do not follow the basic principles of 'buy and hold,' nor do they buy low and sell high. In fact, there is a positive correlation between the performance of an asset class and the level of new investment in it. The relationship is strongest with Canadian bonds, indicating that investors react to an increase in prices by buying into bonds and then selling them when prices fall.

The Hewitt 401(k) index in the U.S., which tracks assets flows between equities and bonds among the DC plans that it administers, illustrates that on nine of the 11 days between Jan. 1, 1997 and the present, when the S&P 500 experienced a significant positive or negative movement (more than 4% in one day) trading activity was above average. In all cases, the trades were toward the better-performing investment vehicle.

Clearly, many investors--whether they be retail investors or members of group retirement programs--react to short-term market fluctuations. Given the difficulty that even professional money managers have in effectively timing the market, this type of activity is risky and unproductive.

The key feature of a DC plan from an investment perspective is the fact that while the plan member bears the investment risk and often directs the investments, the sponsor shoulders the legal or fiduciary risk associated with operating the plan.

By setting up the plan and selecting the providers and investment options, the sponsor acts in a fiduciary capacity. Its responsibilities include offering a reasonable range of investments, selecting and monitoring these options and educating members. Members who make sub-optimal investment decisions in times of market turmoil may attempt to hold the sponsor responsible, claiming they were not properly educated and could not make effective investment decisions.

The best way to reduce the fiduciary risk associated with members' investment decisions is to develop a communication strategy that gives employees the tools they need to make effective decisions in a turbulent market environment, and to reinforce key messages. The communication messages should include the following components:

1. Select an asset mix and stick to it. Employees need to consider certain factors as they set their long-term asset mix. They also need to understand when it is necessary to revisit asset allocation. The key determinants in establishing an effective asset mix are years to retirement, personal tolerance to risk and personal financial position.

Members who will not be withdrawing funds in the short term should ignore market fluctuations and focus on the long-term accumulation of retirement savings. They will need to build an investment portfolio that yields sufficient long-term returns to support their desired standard of living in retirement.

The longer the holding period, the lower the variability of equity returns. For members with a long-term horizon, stocks become less risky than bonds or treasury bills, despite the fact that, over a short period such as one year, the variability in stock returns is significantly higher than in bonds or treasury bills.

Given that investment professionals who study the markets regularly have difficulty timing asset mix movements, it is unlikely that individual investors will be able to do better. In fact, investors can seriously hurt their long-term investment performance by mis-timing the market. For example, by being out of the Canadian equity market for the 10 best performance days between 1991 and 2000, an investor's annualized return over that period would have been reduced by more than one-third. Successful investors set an asset mix based on reasonable expectations, and stick to it, despite short-term market fluctuations.

2. Manage expectations. We have just emerged from one of the strongest sustained periods of investment performance in 100 years in both the equity and fixed-income markets. The environment was created largely by low inflation, declining interest rates, high real interest rates, economic growth and strong returns in equity markets.

The outlook over the next 20 to 30 years may not be as favourable. Baby boomers will begin to retire, causing wage pressures to escalate as a result of labour shortages and stock markets to tumble as they draw down savings. As well, real interest rates are likely to remain low, as government debt declines and savings rates increase. Even if some of these forces can be tempered, it is unlikely that we'll see the double-digit returns of the 1990s early into the 21st century.

All of this means that member expectations about future returns must change to reflect reasonable long-term market expectations. Again, expectations for future returns should be in line with historic return levels. This means a long-term balanced fund should expect to earn a real annualized return of approximately 5% a year.

3. This time is not different. Investors tend to get in trouble when they believe that a temporary change in market circumstances represents a permanent shift in market fundamentals. This type of thinking created the unrealistic price escalation that marked the technology bubble of the late 1990s. We see similar sentiments among individual investors who believe that periods of strong or weak market performance will continue indefinitely.

The message to members is that things are never as rosy as they seem in good times and never as bleak as they seem in bad times. In the current weak equity markets, where many DC members will have lost money in equity funds, it is important for investors to remember that markets move in cycles, and that they will recover over time.

The average bear market, defined as a decline of 15% or more in the TSE 300, has lasted about eight months, and it has taken approximately 17 months from the onset to fully recover market losses. It is important to teach members that if they remain invested in the market, they will participate in its eventual recovery.

4. Rebalancing is important. Asset allocation can drift significantly in volatile markets. Members should be aware of the need to periodically review their asset mix and rebalance it to their long-term targets. Portfolio rebalancing will also help investors trim top-performing asset classes and buy into weaker-performing classes.

While it is important that these messages are repeated, sponsors should avoid advising individual members directly. These messages should be reinforced at the plan level, as part of the basic investor education skill program.

A critical component of managing sponsor risk in volatile markets is a regular assessment of the need for education. This can be done by monitoring plan investment and transaction trends, as well as noting unusual call centre and interactive voice response activity along with sharp increases in transactions during times of market turbulence. Understanding the nature of member inquiries can help sponsors determine which issues are of the most concern to members, and enable them to tailor their messages accordingly.

Similarly, pronounced changes in plan investment trends, such as a sharp shift in the asset mix for the plan overall or the asset mix for a particular demographic group, can signal the need to reinforce key messages.

Prolonged bear markets and extreme market volatility create discomfort and anxiety for institutional investors and pension committees. For individual DC investors, who often have little experience with investment markets, they can cause panic or extreme reactions. Sponsors can help to mitigate their fiduciary risk and increase member satisfaction by ensuring the right messages are repeated and that member reactions are monitored. BC

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