© Copyright 2006 Rogers Publishing Ltd. The following article first appeared in the December 2005 edition of BENEFITS CANADA magazine.
Not defaulting on retirement
Employees need help when it comes to deciding what investment path to take. But there are investment choices plan sponsors can offer that can steer plan members in the right direction.
By Heather Sternberg, Janet Rabovsky and Sue Walton

You’re a defined contribution (DC)plan sponsor and you’ve done all the right things. You’ve selected a plan provider with a strong track record of providing excellent administration and service; you’ve offered just enough funds so that a plan member can establish a diversified portfolio(without getting overwhelmed with too many options); and you’ve provided information and education sessions to enable your employees to make informed investment decisions to help them save for retirement.

But what do you do when your plan member does not provide an investment direction, whether it be for their own contribution or the employer contribution? Many employees, despite being offered education sessions, do not feel equipped to make investment decisions, and often make no decision at all. For some plan sponsors, it is even a challenge to get the members to attend an education session.

However, as a plan sponsor, you are required to make a decision for those employee members who refuse to make the decision themselves by selecting an appropriate default option.

Research shows that the majority of DC plans select a money market fund as the default choice as this is considered a non-controversial option. However, cash funds offer very little in the way of capital appreciation and inflation protection, and should not feature prominently in an employee member’s retirement asset allocation, especially in the earlier years of accumulation. It was originally thought that a money market fund would act as a short-term place to “park” funds, to give members time to evaluate the plan’s investment options and make their decisions.

But according to behavioural finance research, inertia and procrastination shape investor behavior: once funds are in a money market account, they will likely stay there. According to industry statistics from Fidelity Investments, after 10 to 15 years into a plan, anywhere from 20% to 30% of assets will likely be in the default option.

The danger in this is that plan participants who remain in a default option with a money market fund are at risk at not being able to meet their long-term retirement savings objectives. This puts plan sponsors at risk of future litigation from employees who maintain they did not meet their retirement targets as a consequence of an inadequate investment vehicle.

Theoretically, the most suitable default option is a real return bond with a similar duration to that of the member’s working life. However, this option is not practical to offer(there are very few real return bonds available in Canada, much less real return bond funds). While many plans still maintain a money market option as a default fund, increasingly plan sponsors are considering more balanced fund options—usually with a moderate growth objective.

This could mean a balanced fund without a particular style bias or the middle option of an asset allocation portfolio series (known in the United States as life style portfolios. They are a series of balanced funds with the equity allocation adjusted to suit varying risk tolerances.)A moderate balanced fund often translates into a bond allocation of 40% to 50% and an equity allocation of 50% to 60%.

The main advantage of this option is that it offers good diversification and is easy to explain and monitor. However, it does have some weaknesses, such as the inappropriateness of a particular asset mix given a person’s risk tolerance and stage of life (the “one size fits all” issue). Additionally, due to participant inertia, once a particular fund has been selected, a member may never go back to adjust the fund choice to a more appropriate allocation. In order to address this issue, there has been some movement towards utilizing more dynamic portfolios as the default: Life cycle portfolios.

Life cycle portfolios are a relatively new addition to the Canadian marketplace, but have been available in the U.S. for a number of years. Increasingly, they are becoming the default option in 401(k)plans as plan sponsors in the United States struggle with member apathy towards their retirement investments.

What are life cycle portfolios? Also known as targeted retirement date funds, they have a set maturity date and dynamically change the asset mix of the fund, shifting progressively from equities to fixed income as the fund draws closer to maturity. Once a fund is selected that is closest to the individual’s targeted retirement date, the fund automatically augments the asset mix as the employee member ages. Thus, once this type of fund is selected, no other decisions need to be made, making them a good choice for a default fund.

As these types of funds help employee members select an appropriate asset mix and are automatically adjusted to suit their targeted retirement age, life cycle portfolios are becoming a popular option for new Canadian plans. However, before plan sponsors jump on life cycle bandwagon, there are a number of points to consider:
1. Life cycle funds are fairly easy to communicate to members but are more difficult for plan sponsors to monitor; a plan sponsor has to monitor the underlying funds, the asset allocation, and how the asset allocation shifts over time;
2. They are a new product in Canada. There is very little performance history and only a few investment managers who actually provide it. This makes it difficult for a plan sponsor to assess how well the manager maintains the asset allocation and performs in each of the underlying asset classes;
3. There is no opportunity to adjust the life cycle fund to suit a particular individual’s risk tolerance, assuming that all members retiring in the same year have the same risk and return preferences and retirement goals; and
4. If a member decides to change their retirement date, this requires a change in the life cycle fund.

Life cycle funds have been available to 401(k)plan sponsors for approximately 10 years. During this time, the funds’ options have grown and been adapted to meet the evolving needs of American plan sponsors and members. In particular, there have been two developments worth mentioning:
1. Passive Fund products in the U.S. — there are some life cycle products that are composed of passive funds, offered by the large index managers. A life cycle fund composed of passive funds is less expensive for plan members and easier for plan sponsors to monitor. There is also no concern about the underlying funds underperforming the index; and
2. Customized fund products — some large 401(k)plans(US$500 million to $1 billion in size), have been able to create a customized life cycle product, rather than being “stuck” with the pre-packaged products. Generally a recordkeeper customizes these funds in partnership with an investment consultant. One vendor in Canada presently offers customization in its life cycle product, though this could be widely offered by more recordkeepers in the future.

For many reasons, life cycle funds seem to be a good choice for a default option for many plan sponsors. They assist them in meeting their fiduciary duty to provide a range of options to members, and ensure the member is saving enough for their retirement. More importantly, they address one of the issues that many plan sponsors are dealing with today: member apathy.

As the Canadian DC market matures, it is likely that more recordkeepers will have life cycle funds available. Given future rules and regulations regarding DC plans, sponsors will need to offer greater alternatives to make sure they are fulfilling their fiduciary responsibilities. Life cycle funds have the potential to stem the tide of member apathy while at the same time give plan sponsors the peace of mind that they are providing better alternatives that could enhance retirement savings.

Heather Sternberg is an investment analyst and Janet Rabovsky is a senior investment consultant with Watson Wyatt Worldwide in Toronto. Sue Walton is an investment consultant with Watson Wyatt in Chicago. Heather.Sternberg@watsonwyatt.com, Janet.Rabovsky@watsonwyatt. com, Sue.Walton@watsonwyatt.com.