More than eight years have passed since the Joint Forum of Financial Market Regulators released its Guidelines for Capital Accumulation Plans (the “CAP Guidelines”) in May 2004. As more employers choose to sponsor DC pension plans, this may be a good time to take a look at whether the CAP Guidelines have improved investment decision-making by DC plan members and what other asset management options may be available to DC plan sponsors.
The CAP Guidelines
A CAP is a “tax-assisted investment or savings plan that permits members to make investment decisions” among two or more investment options. This definition captures DC pension plans, group RRSPs and deferred profit-sharing plans. The CAP Guidelines describe the duties of CAP sponsors, the most important of which are set out below:
- Establishing the CAP and selecting service providers.
- Selecting investment options for members.
- Establishing a “default” investment option.
- Providing investment information and decision-making tools to members.
- Informing members about transfer options and fees.
The CAP Guidelines do not have the force of law, so plan sponsors are not legally obligated to comply with them. But most DC plan sponsors do so because they are advised that the CAP Guidelines may provide a measure of protection from litigation by plan members. Although the CAP Guidelines do not provide a “safe harbour” in the event of member litigation, the theory is the courts may look more favourably on a DC plan sponsor who can show compliance with guidance issued by pension regulators, even though such guidance may be non-binding.
Employers increasingly prefer to sponsor DC pension plans as a means of reducing their exposure to DB risks that can result in volatility of their pension expense, especially risks relating to investments, inflation, longevity and retirement-income sufficiency. In a DC plan, employees bear these risks; the employer retains only those risks relating to the legal and fiduciary duties of a plan administrator. In addition, DC contribution rates are typically lower than for DB plans.
Potential costs of shifting risks to plan members
The shifting of risk from the employer to the employees comes at a price. A number of studies have shown that DC plan members do not understand their plans, fail to take advantage of member education programs and make poor investment choices—or no choice at all. As an example, a study published by the Organisation for Economic Cooperation and Development (OECD) in 2007 found that individuals who save in CAPs lack the necessary expertise to make sound investment choices and that their investment behaviour is characterized by procrastination, inertia or overconfidence. These findings are consistent with two studies of Canadian DC plan participants conducted in 2004 by SEI Investments. The studies found that DC participants lack investment knowledge and often fail to take advantage of DC education programs. In addition, the studies concluded that education programs are ineffective even when employees do use them. A 2010 OECD study found that many DC plan members are “incapable or unwilling” to make investment decisions and even when they do, often have “behavioural handicaps” that lead to poor decisions.
The evidence that DC education programs are ineffective and that DC plan members have poor investing skills points to some important questions about the CAP Guidelines that every sponsor of a DC plan may wish to consider:
- Are DC plan sponsors and members realizing any value from the investment choice and education that the CAP Guidelines require?
- Is the default investment option appropriate for employees who do not make investment choices?
- Is there a better way to manage DC assets?
Evidence regarding the behaviour of DC plan members as discussed above suggests the answer to the first question is a clear “No”.
The answer to the second question will vary from plan to plan. In choosing a default option, a DC plan sponsor must weigh the risk of capital losses against the risk that members in the default option may not achieve a reasonable rate of return. In the past, many employers have used low-risk vehicles such as money market funds as a default, but there is an increasing trend toward using target date, target risk or lifecycle funds as the default option because they may deliver better investment outcomes. Unfortunately, there is no legislative guidance on what the default option should be. This means that each DC plan sponsor should apply due diligence by obtaining appropriate advice, selecting a default option that is consistent with the design objectives of the plan and the characteristics of the plan’s membership and communicating regularly with members.
Managing DC assets—A better way?
With respect to the third question, many DC plan sponsors might be surprised to learn they are not in fact required to offer investment choice: the CAP Guidelines apply only to a DC plan in which investment choice is offered. This means that DC plan sponsors who are concerned that the CAP Guidelines are not working well for their plan membership have the option of managing DC assets on behalf of members—as do a number of DC plan sponsors in Canada.
Because there is no regulatory guidance for DC plans in which sponsors manage the assets, sponsors will need to develop investment and communication policies that are consistent with their legislative and fiduciary duties. Though they will not have made investment choices or investment education available to members, DC plan sponsors who manage members’ assets will need to do some of what the CAP Guidelines suggest, including communicating the purpose of the plan to members, explaining the risks and benefits of plan participation, conducting periodic reviews of the plan’s investment policy and outcomes, informing members about fees and ensuring fees are reasonable and reporting regularly to members on the performance of the plan.
As with DC plans that offer investment choice, good governance processes and effective, accurate and plain-language communication may be the best protection against legal risk. DC plan sponsors who are especially concerned about legal risk may wish to consider making participation optional and ensure that enrollment forms draw employees’ attention clearly to the terms, conditions and potential risks of plan participation.
Benefits of taking control
As compared to managing assets according to the CAP Guidelines, DC plan sponsors can potentially realize a number of advantages by managing assets on behalf of members:
- Reduced complexity and administration costs because there is no need to conduct periodic reviews of multiple investment options.
- No requirement to educate members about investment options.
- Lower investment management fees can potentially be negotiated due to the economies of scale resulting from managing assets in a single fund.
- Reduced workload for DC plan members.
- Simplified communication.
Managing DC assets on behalf of plan members will not be the best approach for every plan sponsor. In small plans with off-the-shelf designs, there are few economies of scale to be achieved and sponsors may not have the resources to develop customized asset management and communications policies. But for sponsors of large DC plans, managing assets on behalf of members may present an opportunity to reduce costs, improve investment returns and deliver better pensions to members.