Fall 2009

Consideration of DB Features for DC Plans Guide

NAGDCA Automation of DC Plans Taskforce

Background

The Pension Protection Act of 2006 (PPA) provides important safeguards that permit defined contribution (DC) plan sponsors to implement a number of specific defined benefit (DB)-like features. Various studies (see “References” on page 2) have concluded that DC plans underperform DB plans by as much as 1 to 2% per year due to the combined impact of inferior asset allocation by plan participants and higher plan costs. There are many who believe that adopting certain elements of DB plans can significantly improve participant outcomes in DC plans. The protections offered by PPA apply to private plan sponsors under ERISA and can serve as useful plan design guidance to the public sector for this purpose.
 
NAGDCA established the Automation of DC Plans Task Force in 2008 to study DB-like elements being implemented or considered by DC plans and to provide an analysis for NAGDCA plan sponsors who may be considering implementing any of these features.
 
Structure of Guide
 
The Task Force prepared the following document in four sections to address the different elements of the DB-type plan features currently being implemented or considered by DC plans:
 
1.       Asset Allocation Vehicles: Qualified Default Investment Alternatives Under PPA                                
DC plans generally require plan participants to build their own individual portfolios from an investment line up selected by the plan sponsor. The result is a wide range of asset allocation strategies. Many participants take on far too little or far too much market risk for their individual situations. Once in place, inertia sets in and allocations rarely, if ever, change. The result is an extreme dispersion of investment outcomes for participants who have similar employment, salary, age, and other characteristics. The PPA provides a plan sponsor with fiduciary protection against investment losses by participants who are defaulted into a Qualified Default Investment Alternative (QDIA) following a pre-notification period. This section examines the pros and cons of the three QDIAs designated by the Department of Labor: target-risk funds, target-date funds and individually managed accounts.
 
2.       Diversifying Asset Classes: Incorporating Underrepresented Categories Into DC                    
Studies indicate that one of the reasons DC plans underperform DB plans is the underweight positions they carry in certain asset classes that contribute to the stability of DB portfolios (see “References” on page 2.). Labeled as “alternative” investments only a few years ago, these investments are now becoming mainstream. This section will examine several asset classes commonly found in DB portfolios that are now being added to DC plans as part of asset allocation portfolios and sometimes as standalone menu options: real estate, commodities and inflation protected securities.
 
3.       Retirement Income Vehicles: Guaranteed and Non-Guaranteed, In and Out of Plan                            
While many of the best elements of traditional DB pensions can be incorporated into DC plans, the one element that has been beyond the reach of DC plan participants is the DB plan’s greatest benefit: guaranteed lifetime income. In recent years, new product and service offerings have been introduced to the market as in-plan options, or to assist participants when they begin taking distributions at the point of retirement. This section will review features of new living benefit and traditional deferred annuities as well as rollover platforms and non-guaranteed payout options.
 
4.       “Auto Everything”: Complete Automation of the Participant Experience                                            
DC plans have been built historically on the premise that participants are engaged and qualified to build their own investment portfolios after careful consideration of their individual retirement needs. Recent behavioral research indicates this idealized vision is far from reality. The PPA provides protections under ERISA for private sector DC plan sponsors wishing to exert far more control over participant decision-making and outcomes than has been the practice. This section describes a model for complete automation of DC participation including auto-enrollment, auto-escalation of contributions, implementation of Qualified Default Investment Alternatives (asset allocation defaults) combined with re-enrollment of existing participants into those defaults, and, finally, the integration of insurance guarantees into default funds to provide a lifetime stream of income in retirement.
 
For each feature, the guide provides a description, a rationale for considering the feature (e.g., research basis) and implementation considerations.
 
 
Acknowledgment
Special thanks go to the Automation of DC Plans Task Force for its efforts and the development of this guide:
§         Kurt Walten, National Association of Real Estate Investment Trusts, Chair
§         Tim Berry, State of Indiana
§         Dick Davies, AllianceBernstein
§         Michael T. Halpin, State of Maryland
§         Brian McCleave, Prudential Financial
§         Polly Scott, State of Wyoming
 
References
 
"Defined Benefit vs. 401(k) Plans: Investment Returns for 2003-2006", Watson Wyatt Insider (June 2008)
http://www.watsonwyatt.com/us/pubs/Insider/showarticle.asp?ArticleID=19148
 
 "Investment Returns: Defined Benefit vs. 401(k) Plans", Issue Brief #52 - Center for Retirement Research at Boston College (September 2006)
 http://crr.bc.edu/images/stories/Briefs/ib_52.pdf?phpMyAdmin=43ac483c4de9t51d9eb41