Fall 2008

Building a Better DC Plan with Institutional Best Practices

By: Wellington Management

As defined contribution (DC) plans come to represent the majority of retirement savings, there is a growing focus on encouraging savings and applying leading investment practices to achieve an appropriate replacement income ratio for plan participants. In the following interview, Wellington Management Director of Defined Contribution Business Development Jim Sia draws on his 15 years in the DC market to explain how to make DC a success for participants. In addition, Rick Wurster, a portfolio manager in Wellington Management’s Asset Allocation Group, outlines the investment approach he applies to target-date solutions and his objective of closing the gap between defined benefit (DB) and DC returns. Putting the historic transformation of DC into perspective, Jim and Rick provide insights for plan sponsors interested in the next chapter of retirement savings.

Q: Jim, how do you assess the changes we’re seeing in the DC world as traditional DB plans are frozen or eliminated?
Jim: Retirement has been moving away from something that was predictable and managed for you to something participants control: their DC investments. While that may scare some, it is also an opportunity to provide a better retirement. It places greater emphasis on individuals saving properly, getting the most out of their investments, and protecting their assets in retirement.

Target-date funds are a big step toward taking the guesswork out of investing and putting the focus on saving. Moreover, I think the next wave of target-date approaches will be positioned to produce better returns in a more consistent way than today’s approaches. Next generation design needs to smooth the ride for participants, so they don’t feel the downside as much as they do today.

Q: McKinsey recently projected that DC assets would rise from the 2006 level of US$4.1 trillion to between US $7.8 trillion and US $8.5 trillion by 2015. What do those eye-popping numbers mean for DC plan sponsors?
Jim: I think it’s fair to ask if plan sponsors are really ready for that jump. Structural changes in DC plan design, like automatic enrollment and savings escalation, as well as a shift in employer contributions from DB to DC, will obviously have a huge impact on plan size. The average US$500 million plan today, which has, say, 60% participation and a 5.5% savings rate, will see participation climb to about 90%, its savings rate increase to 10%, and assets double to US$1 billion in the next seven years.

Yet it is precisely that asset growth that will spark a paradigm shift in which plan sponsors will stop focusing on the inputs of a DC plan and turn their attention to the plan’s outputs. In other words, as DC assets begin to represent a greater share of the average employee’s retirement income, the replacement income ratio a plan produces will become the central concern of plan sponsors as opposed to the plan’s menu of investment options.

Q: What are the benefits of transforming a laundry list of DC investment options into a target-date structure?
Jim: In the short term, I think it will improve outcomes for participants through lower-cost solutions, more sophisticated premixed options, and greater simplicity. A longer-term benefit would be what I call a better "worst one year." Many participants evaluate their experience in a 401(k) plan by their worst year, not by their average return over time. But if a plan sponsor, advised by a professional consultant or investment manager, structures a more diversified solution, they can make the worst one year appreciably better while often improving expected return.

Q: What are some of the best practices from DB plans that can be applied to DC plans?
Rick: We know from our research that there has been about a 1 - 3% shortfall in the returns of DC plans compared with those of DB plans. We found the number-one driver of this difference was the breadth of asset classes that DB plans have exposure to versus DC plans. For example, DB plans have been invested in a greater percentage of non-US equities, including emerging markets, and have had greater exposure to small cap, private equity, TIPS, and real assets like commodities. A second difference is the use of active management. DB plans often use an active risk budget where they include some passive management to allow for greater levels of active risk in strategies like hedge funds. While hedge funds may not be appropriate for DC, the concept of risk budgeting, and balancing active and market risks, is very relevant, though not often applied. This focus on how allocations to certain asset classes contribute to risk can create far more efficient portfolios with approaches that are not only more flexible in capturing new return opportunities but provide greater downside protection and better performance potential across different market environments.

Q: What are some of the key considerations plan sponsors should address when considering a lifecycle or target-date investment option for their plan?
Rick: The number-one question for plan sponsors is whether to adopt a custom, bundled, or hybrid solution. Various factors can make custom funds attractive: plan sponsors might have scale or the capacity and expertise to build custom target-date funds; alternatively, they might have a unique plan demographic or just a desire to build something non-traditional. For many others, choosing a bundled product is the way to go because of the potential cost efficiencies and simplicity.

The second-biggest question is whether active or passive strategies should be employed. We always remind plan sponsors when it comes to this issue that the most important decision that gets made in a lifecycle or target-date fund - deciding the right asset mix - is never a passive decision. In that sense, all target-date funds are active.

Q: As plan sponsors become more interested in their plans’ outputs than inputs, how will that affect their communication with participants?
Jim: The first job of the new educational message in the DC market is to make participants better savers. We know from our research that about three-quarters of the retirement pot of gold comes from what a participant has saved from ages 25 to 45 and the returns earned from 46 to 65 (Figure 1). We also know that, beyond getting the asset allocation right, there’s a huge opportunity to provide participants with a smoother ride or greater downside protection. That’s especially important because when they do take action, participants typically end up pulling out, saving less, or moving to less risky strategies at the wrong time.

Figure 1:

Q: One of the most complex and yet critical design aspects of a target-date fund is creating an appropriate glidepath. What should plan sponsors look for when it comes to assessing a glidepath?
Rick: We’ve spent a lot of time thinking about glidepath structure, which we decompose into four distinct stages: early accumulation, preretirement, early retirement, and late retirement. In the first stage, the goal should be asset appreciation with as little downside as possible. Here we believe in using as broad a set of asset classes as possible. We also believe in using TIPS as a complement to equities. Most target-date funds end up being dominated by equity risk, so it’s attractive to have something that behaves much differently than equities. TIPS are built to do well when growth is low and inflation is high, the worst environment for equities.

In the preretirement phase, investment returns are more important than at any other stage, yet so is the protection against big down markets. In early retirement, the key is protecting against inflation and large drawdowns while providing capital appreciation to allow for the assets to last for more than 30 years of retirement. In the late-retirement stage, your yield should meet your retirement goals and there should be little investment risk. We recommend that plan sponsors look to their glidepath to provide all of these things: attractive returns with risk-minimizing features; inflation protection; and a high replacement income ratio.

Q: What are some of the more innovative aspects that we might see in future iterations of target-date funds?
Rick: Eventually, I think you will see even more creative strategies bear fruit in a target-date context. One might be to use leverage to reduce, rather than increase, risk. An example of this would be purchasing inflation breakevens as an inflation hedge. You’re taking on leverage but in a risk-mitigating way.

Additionally, I expect we’ll see more protection-based products that guarantee certain replacement income ratios 40 years out - on the order of a mini DB plan. So while there’s still some distance DC plans must cover to catch up with best practices from the institutional DB world, I’m confident that gap will be bridged as DC plans outstrip DB plans in number and size, and target-date funds become the option of choice within those DC plans.

Disclosure: Wellington Management Company, llp is an independently-owned, SEC-registered Investment Adviser which, along with its subsidiaries and affiliates (collectively, Wellington Management) provides investment management and investment advisory services to institutions around the world. Located in Boston, Massachusetts, Wellington Management also has offices in: Atlanta, Georgia; Chicago, Illinois; Radnor, Pennsylvania; San Francisco, California; Beijing; Hong Kong; London; Singapore; Sydney; and Tokyo.

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