Persistent global economic weakness and market volatility have brought the issue of retirement funding inadequacy into sharp focus. And these market realities are creating pressure on DC plan sponsors to find new ways to help plan members accumulate assets and achieve secure retirements.
Industry experts at Benefits Canada’s 2015 DC Investment Forum in Toronto discussed a range of strategies to adjust to the new realities of the DC landscape.
Better Investment Decisions for Better Outcomes
How can the DC industry address retirement income inadequacy?
Siobhain Andreasen, director, Europe & Asia pensions & benefits, at RBC, said retirement income inadequacy is an important consideration in determining plan design and investment selection.
“Most of our plans have a core company contribution and the optional matching contribution component that allows employees to accrue further retirement savings,” said Andreasen. “On the investment side, we ensure we have a broad selection of low-cost funds so employees can have a diversified portfolio in line with their risk tolerance.”
Blair Richards, CEO at Halifax Port IL/HEA, stressed the importance of portfolio rebalancing in building sufficient income.
“Plan members are not going to take the time and become financially literate [enough] to assess risk tolerance and make sound asset allocation decisions,” Richards said. “They ask us to do it for them. So we take asset allocation and investment selection very seriously.” Picking the right investments, however, remains a tough job for many DC plan sponsors.
“One of our big challenges is trying to strike a balance between the right number and the right type of funds,” said Andreasen. “In some of [RBC’s] plans, we have thousands of employees, so we are continuously reviewing our plans, adding funds, replacing funds and removing some.”
She stressed it’s critical to consider a long-term horizon for portfolio rebalancing. “You don’t want to make too many changes,” she said. “You want to make the right changes at the right time and combine [them] with the right messaging” for employees, reminding them of the available plans, the matching component and the opportunities to improve their savings.
There’s also concern participants will overreact to short-term events. Richards said creating barriers to behavioural forces helps prevent poor decision-making.
“We don’t allow plan participants to jump in and out of the funds within 30 days,” he said. “There’s a potential 1% penalty, which would only apply if someone moved both in and out of the same fund within the 30 days. Or vice versa. There’s no penalty for moving to a money market fund, for example, and then to a different fund. That has generally kept people from making really bad decisions.”
To simplify things, many plan sponsors are turning to target-date funds (TDFs) to help ensure investment choices are properly keyed to the ages of participants. According to a Sun Life Financial report, as many as 48% pension plans were using TDFs in 2014.
“We’ve had a lot of success with target-date funds,” said Ben Gallagher, compensation consultant at Niagara Casinos, noting the funds’ simplicity is a big draw. “We have most of our people in TDFs, and it really helps bring them to their retirement date better than if they were handling their own investments.”
The Elements of Target-date Fund Design
TDFs may be simple for a plan member, but their designs are complex, said Peter Walsh, an institutional portfolio manager at Fidelity Investments.
“There are a number of things beyond stocks, bonds and cash—a lot of which have to do with the demographics,” he said. “You should really define what your goal is for plan members, and design TDFs based on that.”
Walsh said tactical asset allocation is key to keeping plan members on track for meeting their long-term objectives of retirement income.
“Active allocation takes a look at where we are in the business cycle, where certain asset classes are going to perform better, and those you want to avoid,” he said. “Active allocation allows you to deviate from the glide path and looks for inefficiencies in the marketplace.”
There are also some risks to consider. “No one has control over what interest rates are going to be, or what happens when central banks start tightening, but they are very important,” said Walsh. “If you don’t keep refreshing your capital market assumptions, you’re going to design something that’s going to be inaccurate.”
He also stressed the importance of inflation protection in strategic allocation.
“Early on, equity risk premium should give us inflation protection,” he said, justifying allocation to North American and emerging market equities. “But once the plan member retires, inflation is going to be the biggest drag on the portfolio.”
Using asset classes such as floating rate debt—real estate that doesn’t have a lockup—is a good way to work inflation into asset allocation, he added.
Keeping Pace With Today’s Markets: The Evolution of Target-date Funds
As more TDFs become a default option for DC plans, providers must close the gap between the target-date offerings and the types of asset classes available to DB plans, said Chhad Aul, a portfolio manager at Sun Life Global Investments.
“This has been a very volatile year in the markets,” he said. “Here, tactical asset allocation makes sense [to help adjust to the] macroeconomic environment and add value by making risk-controlled deviation from the strategic asset mix.”
Adding different asset classes, such as non- Canadian equities and private fixed income, and investment strategies like tactical allocation to the asset mix expands the opportunity set substantially, he added.
“In the equity space, there are various regions you can invest in,” said Aul. “Currencies are another key component of tactical allocation, as are highyield bonds, which provide a buffer against rising bond yields.”
Aul said he was currently bearish on Canada due to two interest rate cuts, high home prices, steep household debt and a weak loonie. “We are underweight Canadian equities and overweight U.S. and international equities, and we’re favouring unhedged exposure because we are positive on the U.S. dollar strength,” he said.
A key area in which DC plans lag DB is access to private asset classes. But Aul said there are ways to close the gap.
“We’ve been adding private fixed income to our target-date offering,” he said. “We’re [boosting exposure to] Canadian commercial mortgages across sectors such as multi-unit residential, office building, commercial and industrial spaces,” said Aul. “These offer significant yield advantages and lower interest rate risk in our fixed income portfolio.”
We Are Living Longer: Now What?
The issue of longevity is also weighing more heavily on retirement planning. But there’s more to the retirement challenge than people simply living longer, said Chip Castille, managing director and chief retirement strategist at BlackRock.
A successful DC pension has three elements. “You need to make contributions, you need to have good investment outcomes, and you need to have access to lifetime income,” he said.
Better plan design can help address the savings issue, said Castille. “Auto-enrollment, auto-escalation and safe harbour protections contribute toward better participation and better savings rates.”
The next part of the equation is professional asset management. “Do you have the right exposure to equities or risky assets for each stage of life?” asked Castille. “Things like lifecycle funds and target-date funds are all expressions of that idea.”
A major challenge of the longevity issue, he said, is the way people compute their retirement needs.
“As an industry, when we talk about investing, we focus on the pot of money itself, but that’s not how we live our lives as individuals,” he asserted. “We live our lives looking at wealth in terms of annual or monthly income, not in terms of pots of money. As humans, we’re very bad at translating pots of money into lifetime incomes.”
And, he added, people have the tendency to overestimate how long their money will last and underestimate how long they’ll live.
U.S. DC Plans: Learnings, Current Issues and Implications
The voluntary nature of nearly all U.S. retirement schemes has created a large coverage gap for workers there, said Jean Young, a senior research analyst at the Vanguard Center for Retirement Research.
“Only about 50% of private sector workers in the U.S. work for an employer that offers a workplace savings plan,” she noted. “And, in a traditional voluntary enrollment design plan, the number of people who actually participate is only around 60%.”
She said auto-enrollment dramatically improves participation, which improves overall employee savings rates across all demographics. “Defaults are extraordinarily sticky because the most common participant behaviour is inertia,” she said. “They do nothing and stay at that default whether the [default] rate is 3% or 6%.”
This behaviour is said to be a key driver of growth in popularity for TDFs. “They’re growing dramatically and are going to dominate DC plans in the U.S. very shortly,” said Young. “Target-date funds are really improving outcomes for plan participants.”
However, she’s still concerned about leakage due to participants’ ability to tap savings accumulated in their plans. “In the U.S., you can borrow from your 401(k) and pay yourself back, and we [also] have the ability to make hardship withdrawals,” she said. “But the real place we have leakage is when you change employers—where individuals can cash out the plan and spend money any way they please.”
Vikram Barhat is a Toronto-based business and financial journalist. Follow him at @vikrambarhath on Twitter.
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