Target-date funds or lifecycle portfolios now represent the most frequently used default investment option for new Canadian DC arrangements. And they are quickly replacing passé default options such as money market funds—which are currently providing a lot of members with negative net returns these days—or balanced funds. Yet it is surprising how many of these pre-packaged, easy-to-use solutions remain quite conservative and basic in how they are constructed.
As the DC market in Canada matures and gains in size, asset volumes are increasingly driving more competition and attracting new players and solutions, and these are all good things for plan members. It happens that there was a lot of discussions at the DC Investment Forum, a Benefits Canada event I attended at the end of September, about how sophisticated investment solutions—something already fairly common in the DB space—could be made available to DC participants.
New but seldom used ingredients
The goal has officially been to reduce volatility through diversification with investments that show low correlation with equities, but there is always hope that higher overall returns can be achieved as well. To do so, large DB plans have already embraced concepts like alternative investments (e.g. real estate, infrastructure, mortgages, absolute return or hedge funds), or more simply geographic diversification (e.g. through emerging market exposure), for some time now.
But using such strategies has only been possible for large DB plans due to the need for sponsor sophistication, necessary plan asset size and, well, for most, financial ability and willingness to spend the consulting fees required to make it happen.
As DC arrangements in Canada tend to be much smaller than DB plans, one might believe that using such fancy asset classes for the DC masses is unthinkable due to lack of critical asset mass.
But DC assets are very concentrated in our country. For instance, according to the 2011 Benefits Canada CAP Suppliers Report, 85% of capital accumulation plan assets are with the top four service providers. Service providers are therefore powerful asset aggregators, pooling savings from DC arrangements of all shapes and sizes.
It would then seem reasonable that these pooled assets be sufficient to justify creating sophisticated DC investment options that would include investment strategies as described above, making them available to all DC arrangements via either target-date funds or in the pre-determined portfolios composing service providers’ life-cycle approach.
Unfortunately, for some reason, inclusion of alternative investments in this context is limited, most often to real estate and mortgages (traditionally core strengths of insurance companies). A situation that some in the industry are actively working to improve.
As for independent investment management firms, they generally seem to have been keener to introduce new asset classes in their multi-class products such as target-date or target-risk funds. This is, perhaps, because a number of them have built solid knowledge and experience over the last 10 to15 years with such products in the U.S.
A nice feature of multi-class funds is that they can be easily used by DC plans of all sizes. The challenge for these third-party products is to gain (or maintain) access to provider platforms, which is highly desirable for plan members as they bring healthy competition to the market and may represent excellent investment options, sometimes with long track records. Sponsor and consultant demand for these products has, up to now, made them fairly available, albeit not necessarily on every platform.
Create your own?
Another approach some DC sponsors are taking is to use the providers’ administration capabilities to create their own, customized lifecycle portfolios.
The rewards can be interesting if there is a real need for a customized approach (based on the participant population’s specifics, for instance) or if it brings significant benefits to plan members (lower overall investment fees, for example).
Creating your own does present some challenges, however, including the need to have access to the alternative asset classes the sponsor is looking for on its provider’s platform (access is improving, but is far from perfect for now) and the will to spend the extra efforts and money to perform the investment design and implementation work required.
One participating sponsor at the forum indicated they would also be wary of the additional fiduciary risk they would feel they’d be taking on by making all these decisions as compared to just selecting a good off-the-shelf solution. “After all, we got out of DB to reduce our risks, so why would we start taking on new ones in our DC plan?,” the plan sponsor said. And a point well made.
Realistically, most plan sponsors don’t have the resources to create their own solutions so the challenge is back in the industry’s hands to provide one. The question is, how far off are we from more sophistication in the CAP market?