When the Joint Forum of Financial Market Regulators released its final version of the Capital Accumulation Plan (CAP) Guidelines, it recommended that a plan sponsor establish a policy outlining what happens when plan members do not provide investment instructions for their group retirement funds.
What happens is that, without those instructions, an individual’s funds reside in the default investment option, which should be, essentially, a temporary parking spot. Unfortunately, for a number of reasons, sometimes assets remain in the default investment option longer than the default’s intended purpose. Consequently, instead of the individual’s retirement savings working, ideally, to grow that person’s assets according to his or her chosen investment strategy, the money sits in a place that may not be appropriate for that individual.
Right now, a lot of money is parked in company default investment options. Recently, a small sample of organizations was asked to indicate which percentages of their employee plan members have their contributions in their plans’ default investment option. More than 30% of their employees did not provide investment instructions, and their contributions remain in the default investment option. A number of respondents simply didn’t know the answer to that question.
Complicating matters is the fact that, out of the same group, some respondents said they do not regularly communicate with their employees on matters surrounding default investment options. Fortunately, many companies do communicate regularly on this matter either because they oversee it themselves or because their consultant or other service provider helps them to do so. Nonetheless, there is concern about employees out there who likely do not understand the intent of the default investment option. They may think of it as a long-term investment choice, which is possible but is not always the case. If they are misguided in that regard, then that indicates a gap in their knowledge, which requires better communications.
Let’s look at default investment options, their evolution over the past number of years and the matters a company retirement committee needs to consider before selecting the default type.
Evolution of default investment options
In the past 10 years, there have been certain trends in default investment options. Many organizations initially selected a money market account as their default, based on the assumption that funds won’t reside in that account for too long. Unfortunately, funds did end up sitting there—and continue to sit there—for longer than intended, and it’s possible, in a low interest rate environment, to chip away at an individual’s invested funds due to the fees involved. This challenges the fundamental investment principle of preserving capital.
When the preservation of capital is the primary intent of a company’s default investment option, a daily interest account provides principal protection, whereas a money market fund may experience a negative return after fees. However, one could argue that the low rate of interest credited to a daily interest account will not keep pace with inflation over the long term. Again, as a short-term place to park contributions, this is fine; as a long-term investment strategy, it’s not appropriate for all plan members.
Today, more plan sponsors are considering target date funds (TDFs) as their default investment option, which at least contain an inherent investment strategy. The investment logic behind TDFs assumes that younger plan members can tolerate more risk (i.e., higher equity exposure) as they have more time to ride the market’s ups and downs. Conversely, a worker who is closer to retirement will want to be conservative with his or her investing so as to preserve capital for looming retirement. (There are always individuals who do not fall into the expected pattern based on age.) Of course, the concern with a market-based investment as the default investment option is the possibility that the portfolio may experience negative returns, even over a two- to three-year annualized period.
In short, Canada does not have a mandated or legislated default investment option, nor do we have safe harbour protection (as exists in the United States), which allows the plan sponsor to select something such as a TDF as the qualified default investment alternative. Nonetheless, this U.S. trend toward TDFs as a default investment option is migrating north to Canada. Regardless of the default under consideration, it should be selected with a conscientious awareness of what might occur if an employee leaves his or her contributions in the default investment option for longer than intended.
Ongoing communication required
Do what you can to communicate with plan members on this matter. For example, do you have a CAP policy statement? Not every organization crafts a CAP policy statement, yet that is one of the requirements of the CAP Guidelines: to document a plan purpose. This statement should articulate (at a high level and in plain language) both employer and employee responsibilities, how to access more information and education, and the purpose of the default investment option.
After the CAP policy statement is finalized, plan sponsors should do the following:
- circulate the policy statement to employees as a communications piece to heighten knowledge of and appreciation for the CAP;
- encourage plan members to periodically review their investment strategy and to take (or retake) the provider’s investment personality questionnaire to ascertain their level of investment risk tolerance; and
- direct them to the investment options available in the group retirement plan and tell them about the differences between selecting a predetermined portfolio of diverse investments selected according to one’s age and/or investment personality as opposed to creating a custom portfolio.
The idea is to save and grow money for retirement, not just let it sit.
Mark Dowdell is senior vice-president of retirement and investments, and Dianne Tamburro is vice-president of retirement and investments with Pal Benefits.