Let’s examine the 2008 performance of the forty-one 2010 U.S. TDFs in Morningstar’s database, representing investors who are just a few years away from retirement. It is alarming to see that the worst-performing 2010 fund posted a return of -41.5% (with a 65% equity allocation) while the best-performing fund had a less detrimental return of -3.6% (14% equity allocation).
Such divergent performance indicates that plan sponsors can bear liability for their choice of TDF offering. Is this a risk they wish to assume? The “set and forget” approach carries significant risks to the plan sponsor and members, as it assumes the asset mix is continuously appropriate.
Designating Defaults
Selecting an appropriate default option is a daunting task. In a perfect world, there would be no need for this, as each plan member would make his or her own investment choices. In practice, however, sponsors are left to invest account balances when no member instructions have been given. Historically, plan sponsors have opted for money market funds as a default vehicle, as they bear the least amount of capital risk.
While default options are meant to be temporary in nature, industry practitioners acknowledge that monies in these funds often stay defaulted for long periods of time. Consequently, plan sponsors are moving toward selecting funds with some level of equity exposure to allow for future capital growth. Such an approach suggests that a more fully invested portfolio is more appropriate, over the long term, for the accumulation of assets to support retirement.
By using TDFs as the default, plan sponsors have distanced themselves from the selection of how much equity should be in a default option by adopting the TDF’s glide path. The younger the demographic of the “defaulting” members, the more aggressive the equity allocation in the default will be—a far cry from the days of money market funds.
Furthermore, plan sponsors should realize that while TDFs have been accepted by U.S. regulatory authorities as one of the qualified default investment alternatives available to plan sponsors, no such status has been granted to TDFs in Canada. Sponsors may find themselves in a position whereby they need to justify not the selection of TDFs as a default option but, rather, the particular product selected and the glide path it uses.
Underwriting Equity Risk
In these difficult times, products offering guarantees of principal or retirement income are appealing and may appear on your members’ wish lists. Plan sponsors should do their research and think long and hard before introducing such features. No investment is truly risk-free, and even the safest investment products can run into trouble.
Sponsors may hope this new breed of guaranteed products will help their members take on the equity risk they need for growth without the risk of losing money. However, plan sponsors need to have a greater understanding of the implicit costs associated with capital guarantees—whether they come in the form of higher fees or altered investment processes that reduce overall returns.
Given today’s market conditions, in order to administer the guarantee, some guaranteed products may have been forced to move to a far more conservative stance than the plan sponsor or members may realize. After all of the recent losses, sponsors may wonder whether this is indeed the time to pay for such a guarantee. Adopting guaranteed products now may be like buying a padlock after the door has been held open.
Finally, plan sponsors need to consider the counterparty risks involved with these guarantees. As we’ve seen in this past crisis, any organization—regardless of its size—is a candidate for financial failure if its risk exposures move unexpectedly. Insurance company stock valuations have come under huge pressure as investors begin to understand the nature of the risk they assumed by making capital protection promises to investors. In fact, one large insurance company has recently announced that it will be increasing product fees and offering fewer features, such as bonuses and resets in guarantee payouts. Other such announcements are likely to follow. In the end, plan members will need to either bear the investment risk (with the corresponding risk of loss) or accept lower returns and higher fees to cover the transfer of risk.
Plan sponsors continue to face many challenges in fulfilling their fiduciary obligations, and there is no easy solution. TDFs and principal guarantees, like all investment products, carry inherent risks. While they may form part of a successful investment offering, the selection and oversight of these products is as crucial as with any other investment option. And, since one size does not fit all, each plan sponsor should consider a customized solution dedicated to the specific needs of its members.
Sponsors need to appreciate that, until the government offers some form of regulatory guidance, they will be best served by helping members to understand the fundamental principles of their CAPs. This is not an easy task. However, it represents the best investment that a plan sponsor can make, in terms of securing an appropriate retirement for its plan members while assuming the least amount of sponsor oversight risk.
David Lester is director, national accounts, and Andrew Kitchen is managing director, solutions and strategy, with SEI’s Toronto office.
dlester@seic.com
akitchen@seic.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the June 2009 edition of BENEFITS CANADA magazine.