DC Pensions The Pendulum Swings … Back
By: Joan Johannson
Just as markets swing back and forth between bearish and bullish behaviour, so too, it appears, do attitudes towards pension plan governance and management. This is clearly in evidence with Defined Contribution pension plans.
As many of us recall, DC plans were originally created as a viable alternative to Defined Benefit plans. Whereas DB plans were, by nature, extremely paternalistic, placing the entire burden of providing a specific defined benefit (income level) to retired employees on the shoulders of plan sponsors, DC plans were the opposite, empowering employees to take charge of their own retirement savings. DC plans provided, and still provide, a means for plan sponsors to facilitate their membersʼ self education, planning, and investment decisions towards creating a program which will see them into a comfortable retirement. The many features of these plans have, for years, been designed to assist members with their decisions – how much to contribute, for how long, how much risk they can afford to take on, and so forth.
Decision Support Tools – Trends Towards Empowerment
The focus in the 1980s and 1990s was generally upon providing superior decision support tools and a broader selection of investment alternatives. During this period, such extremes were considered as sector funds and self-directed plans with no limitations to the investment universe. This was the furthest that the pendulum could swing in terms of leaving investment selection, and its attendant risks and outcomes, in the hands of the plan members. This period of near euphoria, sometimes referred to as ʻthe new economy,ʼ was interrupted by a drop in markets across North America creating a major correction in our economy. The pendulum immediately began to reverse direction.
The Swing Back to Paternalism
Today, we see a trend very significantly away from empowerment and towards the type of paternalism that looks very markedly like a DB plan – just without the actual defined benefit. The current trend is simply to accept that it is only human to shirk oneʼs responsibilities, even towards oneʼs self, and to provide tools that will make administration of programs easier. This simplification is very enticing and each tool, in and of itself, does have a role for specific plans given their needs and purpose. It is the combination of these tools which leads to potential risks for both the plan member and plan sponsor. After all, do DC plan sponsors really wish to court the possibility of assuming investment risk for their DC plan members? Is this not one of the significant differences in the intent of the two alternatives?
Lets look quickly at these tools.
The first is the automated enrolment feature. This is designed to lighten the workload for HR departments, to ensure all employees are part of a program (especially when mandatory), and that there is a means for activating the payroll contributions. Sounds ideal, and it can be, if followed with disciplined procedures to collect member signatures on the requisite paperwork. Having the right paperwork in place allows the plan sponsor to:
- Avoid an administrative nightmare for the plan sponsor and the likelihood of litigation for the heirs in the (no longer rare) case of the death of a previously divorced plan member.
- Ensure proper authorization is required, in line with privacy legislation, should there be questions and investigations required into specific member plans.
- Ensure the selection of at least the first investment option indicating that the plan member is aware of their roles and responsibility in this regard.
Default investments were initially introduced as a short-term ʻparking spaceʼ for member contributions while they made longer term, informed decisions. For such a use, money market funds were often recommended and make sense as one of the safest forms of investment selection.
However, human nature being what it is, many of these plan members never took the next step. Herein lies a huge challenge for plan sponsors and their record keepers. Although there are programs on the market which operate extremely successfully without any default option, even for thousands of plan members, many plans have 20 per cent to 40 per cent of their members in the default option long after the enrolment stage. This is potentially an area of high risk. Any default option, by its very definition, is an investment selection made for the plan member by the plan sponsor.
‘Target Date’ Lifecycle Funds
Now we turn to a very recent entrant to the DC investment universe – target date lifecycle funds which reposition plan members, ostensibly for life. These are the successors to balanced funds which offer diversification and returns beyond the expectations for a money market fund. Where balanced funds were ʻone size fits all,ʼ the new funds add another element in terms of time horizon. These funds, if selected actively by the plan member, may well provide the best ongoing fund management for the member for the course of their time with the plan. In the U.S., where safe harbour is provided under ERISA, these funds have enjoyed great popularity and are found in about 40 per cent of plans.
However, in Canada we do not have safe harbour provisions. We also are in the early days of such funds and offerings tend to be tied to the recordkeeperʼs platform and, therefore, are not transferable to other platforms creating a potential fiduciary conflict.
Also, they may not offer diversification of management styles and are difficult to benchmark. As such, determining their expected returns are a challenge when using calculators to define appropriate contribution levels.
We expect that future generations of these funds will likely address many of these concerns. However, today, the early versions present these problems. When provided as a default selection, the implied endorsement may well magnify the potential of these risks.
Automate Incremental Contributions – A Positive Note
There is a new feature that supports this ʻhands-freeʼ approach to member involvement in DC plans which may actually provide only upside to the member and sponsor. This is the possibility of automated incremental increases to contributions.
When the paperwork is done properly and the member has chosen this feature, it provides a nearly painless way for members to increase their savings potential over time. Again, it is advisable to have a member signature on the paperwork supporting the decision. However, in the end, the member will benefit from further savings.
While each of the above features has a beneficial use within a plan individually, in combination, they represent a trend towards paternalism which actually discourages the likelihood that a plan member will take charge. After all, if a plan member does not enroll themselves in the plan, does not select an investment, is positioned in a fund ʻfor life,ʼ and does not determine their level of contribution or incremental increases, what will ever prompt them to suddenly take any responsibility? Why should they attend a seminar or use any of the decision support tools or calculators provided by the plan sponsor? Is it likely they will ever avail themselves of financial advice or even access the fund information provided? Will they be suitably invested? Will they contribute enough? They have, in effect, been dropped into a plan where every decision is made for them.
Easier For Everyone
Yes, there is no question that this combination of features makes life easier for everyone. But is it right? At the end of the day, if savings are insufficient for even a modest retirement, who will be at fault? Are we making decisions today that are only pain-free in the short term? Market corrections changed the swing of the pendulum with the change in the century. Perhaps it will be litigation that next changes the pendulumʼs swing. There are good reasons why employee empowerment is so much a part of the fundamental principles of a good DC plan. Perhaps this should be kept in mind when considering how all these plan features work together as opposed to simply the value of each in isolation.
Joan Johannson is managing director and senior vice-president at Integra Group Retirement Services.
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