In the 1970s and early 1980s, defined benefit plan members clamoured for the portability provided by converting their plans to defined contribution arrangements. But that enthusiasm has waned over the years, with the majority of capital accumulation plan members simply not up for the challenge of managing their own investments.
For plan sponsors, concerns also include the administrative and fiduciary challenges of CAPs, as well as the potential financial and legal risks. In addition, they face challenges in providing accurate and effective communication and education to CAP members.
Part of the problem is that CAPs are often overly complex, so a simpler approach could benefit all stakeholders.
It’s important for CAP members to have a basic understanding of the investment and risk concepts usually reserved for investment professionals. It requires far more time and effort than most CAP members can handle to come to grips with styles, asset classes, diversification, risk (in various forms), benchmarking, risk profiling, retirement funding and time versus timing.
As well, CAP members must often contend with 15 to 25 (or even more) investment choices, which may include lifecycle and balanced funds; large and small Canadian, U.S. and foreign equity funds; bond, mortgage and real estate funds; daily interest and money market funds; and guaranteed investment certificates. While record keepers provide education, decision-making tools and communications, it isn’t surprising that CAP members struggle, and are often overwhelmed, with this mass of concepts and information. The situation is begging for simplification.
Realistically, the majority of CAP members are unsophisticated and inexperienced investors. Is there a message in the number of available choices? For example, if 12 options include a bond fund, a money market fund and a CIA and nine equity options, is there a subliminal message about where to invest?
It’s also unlikely that plan members, or their employers, are receiving all of the relevant performance information that’s required to manage investments in a long-term horizon.
Plan sponsors that provide a large number of investment options likely do so under the misconception that it improves diversification and/or returns. However, under the Canadian Association of Pension Supervisory Authorities’ guidelines, a plan sponsor is only required to provide sufficient options to ensure an adequate degree of diversification. The pooled registered pension plan regulations also offer some insight on the issue of diversification versus the number of investment options, with only six choices allowed, including a default fund.
Knowledgeable investors argue that a one-fund approach using a balanced fund or a series of asset allocation funds would provide sufficient choice. But catering to a very limited number of CAP members who think they need a lot of investment choices shouldn’t drive the selection of investment options; the sponsor should focus on the needs of the vast majority of members. Therefore, reducing the number of investment options is an obvious way to make a CAP simpler and less costly but still effective.
Taking simplification a step further, plan sponsors could also consider using passive investment options in combination with fewer investment choices. This offers several advantages from both a fiduciary and member perspective. A limited number of passive investment options, covering the major asset classes, would likely provide an effective investment framework for most plans. It also makes investment communications and education much simpler.
From a fiduciary, pension committee and plan member perspective, simplifying the CAP investment platform has many advantages. These include:
- Reducing the education and communication requirements in terms of time and costs;
- Simplifying communication and education processes;
- Simplifying performance monitoring;
- Lowering administrative costs; and,
- Simplifying manager searches and reducing the required time, as well as costs.
Do complex CAP investment platforms offer any significant benefit for CAP sponsors and members? Given the demographics and lack of investment sophistication among members, it’s easy to argue that the plan sponsor is acting prudently by simply providing a suite of passive asset allocation funds plus a few stand-alone passive investment options, covering the major asset classes.
Using a simpler approach won’t eliminate the issue of CAPs generating insufficient pension incomes, but it will make CAPs more friendly, effective, easier to communicate and less costly for all stakeholders.
Gerry Wahl is managing director of the PensionAdvisor.