Preparing for DC 3.0
“DC 3.0 is happening now as a ripple that’s going to turn into a wave,” said Phil Maffei, managing director, strategic guaranteed income solutions, at TIAA. “DC 1.0 was the advent of the 401(k) plan and 2.0 was the Pension Protection Act and all the positives that target-date funds have brought for us.” DC 3.0 is characterized by three key trends, he said: “changes in plan design, the acceptance and adoption of in-plan lifetime income solutions in a holistic decumulation strategy, and personalization to wrap it all up. All three will be game-changers for the industry as we look out over the next two, five, 10 and even 20 years.”
A key driver of innovation in defined contribution today is automation and the do-it-for me mentality prevalent among Americans, said Marina Edwards, senior defined contribution strategist at Invesco. “We’ve already experienced the very positive effects of plan auto features like auto-enrollment, auto-escalation, auto-rebalancing and even the automation of target-date features. The industry seems to be gearing up for an automation supercharge. That supercharge is the annuity components, emergency savings accounts being built into the savings hierarchy and [health savings account] tax savings efficiency,” she said.
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“Innovation tends to happen quite slowly in the DC space and is often led by some combination of legislation, regulation and litigation,” said Nate Miles, head of retirement at Wells Fargo Asset Management. “For the past several years, litigation has been the key driver as plans have looked to remove underperforming managers or ensure they are invested in the lowest share class or lowest-cost vehicle available as they’ve moved to [collective investment trusts]. If you look forward six to 12 months, legislation and regulation through SECURE 1.0 will start to have even more impact on innovation,” he said, referring to the Setting Every Community Up for Retirement Enhancement Act of 2019.
Building a Better Engine
“Traditionally, in regulated industries like financial services, regulatory change incites innovation,” agreed Roger Marinzoli, senior managing director and head of strategy and execution at TIAA. “That desire for innovation also comes from customers who are thinking about their needs differently as the environment and regulations change, as well as the suppliers who innovate to provide better outcomes for their customers.”
The SECURE Act has lifted all levels of interest in lifetime income solutions across all types of industry providers, he said. “Whether you talk about the fintech world’s personal portable pensions, which create parallel supplementary pensions, to actually changing how record-keeping glidepath management and managed-account provisions work to serve plan participants, these innovative developments are being driven by regulatory and demographic changes.”
Elaborating on the advancements in technology to serve the do-it-for-me participants, Invesco’s Edwards pointed to participant data aggregation in a single hub and the development of rules-based programs with easy-to-understand ‘if/then’ logic.
“For example, contributions can go first to an emergency savings account, or ESA, and when the ESA savings goal is met, then payments automatically flip to the 401(k) plan. If the participant accesses the emergency savings account, for example, to purchase new tires, the logic detects that action. So payroll gets a notification to send the next contribution back to the ESA rather than to the 401(k),” she explained.
“The other side of innovation we see is a fresh look at investment menus to better address the needs of participants who don’t want a target-date fund,” added Greg Jenkins, head of institutional defined contribution at Invesco. “They are often ill-equipped to manage their accounts appropriately with [the] single asset class funds that most plans have in their core menus. A lot of plan sponsors are looking at risk-based funds and white-label funds that have the professional management and the appropriate diversification for these participants,” he said.
Some of the plan design changes that sponsors are considering include allowing for partial distributions and annuitizations, as well as adopting professionally managed asset allocation solutions, each of which can help participants achieve better outcomes, according to Maffei. “We believe employees are going to start almost demanding access to institutionally priced, in-plan lifetime income solutions because they’re going to start seeing illustrations of lifetime income on their statement,” he added, noting that the SECURE Act’s safe harbor and portability provisions have encouraged many plan sponsors to explore these products.
Holistic Lens On Employee Wellness
The breakout of COVID-19 last March and the uneven economic recovery has led DC plan sponsors to focus on better understanding the differing impacts on different segments of their plan population, said WFAM’s Miles. “The one lesson from COVID-19 is that people are quite resilient. The majority of participants continued to defer pay to their DC plans every couple of weeks and invested right through the period,” he said, adding, “The other lesson is that the K-shaped economic recovery is impacting DC plans.”
The Wells Fargo 2020 Annual Retirement Survey of plan participants found a stark difference between two types of workers: 19% of workers not impacted directly by COVID-19 (in terms of loss of work hours, loss of income, or complete loss of job) said they had done one of three things: started saving less or stopped saving altogether; pushed back their retirement date or went back to work if in retirement; or deferred or delayed payments on a monthly living expense. But for workers who were impacted directly by COVID-19 (by the same terms), the number of respondents who took one of those three actions jumped to 45%, Miles said. The survey also showed that 75% of workers directly impacted by the coronavirus said that having an employer-sponsored emergency savings account would help them save for these types of unforeseen events and not force them to access their long-term savings.
“We’ve all seen the shocking statistic that 40% of Americans would not be able to cover a $400 emergency or unexpected expense,” Invesco’s Edwards said. “Employers are expressing true care about this issue — not surprisingly — and automatic payroll deduction into emergency savings accounts is centerstage as an easy solution. We’re seeing plan sponsors evaluating whether they should offer these ESAs inside the 401(k) account or open them outside of the plan in bank accounts. It is too early to tell if there is a preferred approach, as we have seen employers implementing both approaches.”
“Another area of focus is student loan debt repayment, with a broad spectrum of approaches ranging from simple payroll deductions for loan repayments to employer-assisted loan repayments,” said Edwards. At the far end of the spectrum, she noted, would be an employer making a 401(k) match-like contribution on the student loan repayment, which are part of what’s known as the “SECURE 2.0” bills in Congress.
Many plan sponsors recognize the threat of mounting student debt to retirement readiness and are exploring student debt-aid programs, according to Maffei at TIAA. He said the SECURE 2.0 bills in Congress would allow employers to help pay down student loans in lieu of making a contribution to the retirement plan.
Extending the theme of retirement readiness, Maffei’s colleague Marinzoli pointed to three ongoing areas of interest: “healthcare savings plans with their triple-tax advantages as investment vehicles, retirement savings via lifetime income solutions, and guidance and advice that helps participants through the incredibly complex world of how to prepare for the time they’re no longer working. That advice is at the core of the theory of financial wellness.”
“While financial wellness means different things to different plan sponsors, they are focused on it as they’re hearing from participants that they need help,” said WFAM’s Miles. “But in general, their budgets are pretty constrained, particularly on the wellness side of that benefits ledger. A big priority for plan sponsors is to spend their money as effectively or as efficiently as possible, and often it’s on the basic things that they can move the dial, such as building awareness of retirement security and developing what we call a ‘retirement-planning mindset’ in plan participants that combines near-term and long-term planning to [help them] have confidence in their financial future,” he said.
Paths To Improve Retirement Income
The COVID-19 pandemic outbreak paused the swell of interest generated by the SECURE Act in exploring and adopting retirement income solutions as employers had to shift to addressing more immediate financial needs of participants.
“We’ve seen an uptick of interest from consultants and advisers since December 2020 and expect a lot more movement on the retirement income front by the second half of the year,” Miles said, echoing similar activity experienced by the other industry providers. In the 2020 Wells Fargo retirement study, 70% of plan participant respondents said that they were concerned about making their money last in retirement. “So even on the participant side, the pandemic will have a long-lasting impact on their awareness of the need for retirement income,” he said.
“What we’re going to see is the corporate retirement space and 401(k) plans now learning from 403(b) plans, which have always included lifetime income products within them,” TIAA’s Maffei said. “At TIAA, we’re paying lifetime income to over 30,000 individuals over age 90, including almost 200 people older than 105. The lifetime income products that we deliver provide personalization and expand access to a predictable, sustainable income check for life, a personal pension of sorts,” he said. TIAA and its College Retirement Equities Fund offer a robust suite of fixed and variable annuities within institutional retirement plans, he said, while other lifetime income solutions exist in the broader market, including guaranteed minimum withdrawal benefits, or GMWBs, and qualified longevity annuity contracts, or QLACs.
A Host Of Initiatives
The DC industry is closely watching SECURE 2.0, which includes two bipartisan bills: the Portman-Cardin Retirement Security and Savings Act, sponsored by Senators Rob Portman, R-Ohio and Ben Cardin, D-Md.; and the Securing a Strong Retirement Act, sponsored by Congressmen Richard Neal, D-Mass. and Kevin Brady, R-Texas.
Notable proposals include:
- Increase the catch-up contribution limit for those 60 and older
- Increase the starting age for required minimum distributions to 75 from 72
- Exempt those with under $100,000 balances from required minimum distribution rules
- Require new plans to include auto-enrollment and auto-escalation
- Permit matching contributions for employees repaying student loans
- Allow 403(b) plans to invest in collective investment trusts, and
- Allow 403(b) pooled employer plans
“One provision of SECURE 2.0 that’s gaining attention is the allowance of the 403(b) plans to invest in CITs,” said Edwards at Invesco. “This is long overdue, and we are excited to see the material benefit that this will provide to 403(b) plan participants. We believe that this provision will require 403(b) plan sponsors to take fiduciary considerations in reviewing their investment lineup, because we’ve seen lawsuits target plans that offer mutual funds when lower-cost CITs were available,” she said.
The provision requiring auto-enrollment and auto-escalation for more retirement plans is important because getting more people into plans with more velocity and at higher contribution rates can also vastly improve participants’ retirement confidence,” TIAA’s Maffei said.
“We feel pretty strongly there’s a greater than 50% chance that we get SECURE 2.0 within the next 18 to 24 months,” Miles said.
Lifetime Income: In Or Out Of The Default?
“Retirement income is a very difficult problem to solve, with many variables and a wide range of philosophies among plan sponsors on how to address this challenge,” said Invesco’s Jenkins. “Some employers want to try and solve this problem for their entire workforce with a default solution. Others want to give participants options that they can elect on their own. There’s a lot of innovation by record keepers and investment managers in delivering a variety of new approaches to fit different participant needs.”
As plan sponsors explore different solutions, “we expect to see a lot more focus on financial wellness and more work on helping participants transition to decumulation,” he said.
“There isn’t consensus on which way the market will evolve for retirement income to be included in the default or outside it,” said Miles at WFAM. “We’re seeing plan sponsors starting to explore products for retirement income outside of the default fund. That could be within the core menu or incorporating an annuity with a drawdown fund,” he said, adding that he expects to see more innovation in the income nondefault market over the next 24 months. “Looking back, we will say it was SECURE 1.0, then it was core menu, and it will eventually get to the default,” he said.
Pooled Employer Plans Across The Spectrum
If we think about the question, “‘What is one of the most important retirement innovations for the country?’ the MEP/PEP evolution may well prove to be one of the biggest changes from a regulatory-enablement perspective that we see in the next 10 years,” said Marinzoli at TIAA, referring to multiple employer plans and pooled employer plans.
“There’s an enormous population of employers that don’t have the time, expertise or budget to handle administering a retirement plan. With PEPs that offer centralized investment selection with scale pricing and potentially lifetime income options, it would make a double difference in their employees’ lives,” Maffei added.
“Fees are going to be really important, as well as the oversight process, for these pooled plans,” Miles said, adding that he sees these evolving on the small end of the market, and moving upmarket as well. “In this digital-first world that we’re living in, what does that delivery mechanism look like for the plan sponsor and, importantly, the plan participant? Who can deliver retirement success for plan participants not just at the point of retirement but … throughout that retirement period?”
“One of the bigger game-changers to the industry is going to be that the pooled employer plans and the innovative PEP structures will be driven by technology,” said Edwards at Invesco. “Not only will PEPs for small plans expand retirement coverage to millions of Americans, but mid-size and large employers will want to consider dodging that ERISA litigation bullet and outsourcing the plan fiduciary complexities to the experts,” she said.
“One of my favorite sayings is, ‘Big ships turn slowly,’” she added. “We know from our 401(k) path that new initiatives, like target-date funds or auto-enrollment, took some time to gain momentum in adoption. The adoption of PEPs will take two to three years and will eventually be just as commonplace as the automatic plan features that we’ve seen in the past.”
Is Your Default Where It Should Be?
With almost 80% of plan participants in the qualified default investment alternative, or QDIA, which is typically a target-date fund, plan sponsors are exploring more custom solutions to improve retirement outcomes.
“The custom target-date solution is where we see the puck going … in the subsegment of 403(b), with TIAA’s Retire Plus, and we also see it evolving in the 401(k) world,” said Marinzoli. “The customization and personalization at the participant level allows more open architecture for the plan sponsor to include a broader array of products, like annuities, real assets or alternative assets,” he noted.
One example of customization is to incorporate plan demographics by differentiating scenarios for participants who work in industries with more physically dangerous jobs, and thus typically retire early, versus those retiring later from, say, legal firms, TIAA’s Maffei explained. “When you have the modeling acumen and technology to develop more customized defaults and then fold in products like lifetime income or diversifying asset classes like real estate, you have the potential to create better retirement outcomes,” he said.
“Target-date funds dominate the QDIA landscape, but they’re definitely not all the same, and fiduciaries need to take extra care when evaluating them,” said Jenkins at Invesco. “The fiduciary road map that the [Department of Labor] issued in 2013 still remains the best guidance for plan sponsors. It’s always about the process more than the end decisions — how you made the decisions and that you documented them — that is important for fiduciaries.”
Revisit Asset Allocation
While today’s low interest rate environment is expected to persist for some time, the chances of rates increasing have improved as the Biden administration’s $1.9 billion stimulus package adds momentum to the nascent economic recovery, driving up the specter of inflation. Given this backdrop, sponsors are revisiting their asset allocation.
“Plan sponsors need to address the potential risks of a rising rate environment or just a different fixed-income market than what we’ve experienced in the past, particularly given the proliferation of passive fixed-income on plan menus,” said Miles at WFAM. “Do they have appropriate choice in their core menu on the fixed income side? There’s room to add to the fixed-income side of the ledger, whether as a core or core and core-plus option, as a passive or an active option, which is particularly important as participants approach and enter that retirement phase.”
“Intermediate-term fixed income is what you see most often in DC plans, and yield has been very hard to find in this space. It’s common to see six or seven equity options on a plan menu, but only one fixed-income option,” noted Jenkins. “One remedy is to consider adding a more diversified fixed-income option that can take advantage of emerging market debt, structured credit and some other areas that may deliver better returns in the years ahead.” Some clients are also revisiting their capital preservation options and considering stable value instead of a money market fund.
“Another area to consider is annuities that are still very attractive at low interest rates because of mortality-risk pooling. Many annuity contracts, particularly guaranteed annuities, provide a guaranteed minimum interest rate,” Maffei said. “When you add guaranteed annuities to a target-date structure, replacing some of the fixed income, you help smooth out the volatility, provide downside protection for that portion of the portfolio, and still deliver competitive lifetime income payouts despite the low interest rate environment.”
Industry providers point to white-labeling and CITs — particularly with the SECURE 2.0 proposal for 403(b) plans to use CITs — as key areas of interest for plan sponsors. Activity in white-label funds resumed in the second half of 2020, according to Miles at WFAM. “Larger plans are looking to consolidate their plan menus and simplify lineups, but also provide broader investment exposure. We’re watching whether this activity will move down-market, as smaller funds may find it can be cost prohibitive. For instance, can managers with enough depth and breadth create their own white-label funds to provide access to, say, a midcore option?”
He added that smaller plans are also using CITs, which isn’t unexpected as they face fee litigation risk as well. “We would not be surprised if CITs overtake mutual funds from an asset perspective over the next several years,” Miles noted.
“With a white-label menu, you have fewer broader options that are professionally managed and diversified,” said Jenkins at Invesco. “For example, instead of offering six or seven equity options like many plans do, you can have one U.S. equity option and one diversified international equity option. Another area where we are seeing interest in white-labeling is real assets, which may include investments in real estate, infrastructure and commodities, for example. White-labeling also makes it easier for plan sponsors to manage the process of changing underlying managers or components without disruption to the menu.”
Societal Waves On DC Shores
“An early approach was to put an ESG equity option on the menu. These were typically very expensive and often misunderstood by participants who put all their money into that option,” Jenkins said. “A more evolved approach is to potentially offer balanced or risk-based ESG options, so that participants who want to invest this way get a diversified, professionally managed portfolio,” he said.
Another more advanced model is to select investment managers that implement ESG factors into their investment process. “You’re keeping your investment menu structure the same but ensuring that your managers include ESG as part of their investment process,” Jenkins said, pointing out that there are not only active strategies, but also low-cost, passive ESG options — both custom and off-the-shelf.
“There’s a growing demand in the DC industry not just for ESG, which TIAA has been engaged in for the last 30 years, but also socially responsible investing for ethical guidelines and impact investing,” Marinzoli said. “Millennial surveys show a lot of desire and interest in this space, and this group will continue to drive demand for ESG investments and engaging on ESG criteria, both within retirement investing and general investing.”
TIAA’s 403(b) plan clientele tends to be very paternalistic and, for some, ESG is a key consideration of their plan portfolios, Maffei added, noting that TIAA created its first custom ESG fund for an institution a year ago. In that same vein, diversity and inclusion is a business priority both within TIAA and its very diverse customer base, he said.
While there is a lot of interest in ESG by plan sponsors, for the most part there’s not been a ton of action, cautioned Miles at WFAM. He, and the others, point to some uncertainty on the regulatory front and the fact that some plan sponsors are looking for further clarification on ESG investing in terms of financial factors considerations by the Department of Labor under the Biden administration.
“Our clients certainly want to understand how they might consider incorporating ESG and diversity and inclusion into their DC plan menu. They want to know how their investment managers incorporate these factors in investment decisions,” Miles said. “Plan sponsors are also looking at what DI looks like across their managers and investment and analyst teams. While we wouldn’t expect managers to be changed based on that review, we do expect going forward DI will increasingly become part of the calculus when a plan sponsor makes a determination for a new manager.”
The Digital Shift
“Communication is not simply about greater guidance and advice, but the social networks themselves have expanded to the point that people have a global perspective through social media, and that will continue to affect their financial perspectives,” said Marinzoli at TIAA. “It’s about meeting customers where, how and when they want to be met. We’re investing in digital technologies, video, mobile and chatbots,” added his colleague Maffei. “We’ve found, for instance, that more people are checking their retirement account balance on mobile devices, and using them to transact with our TIAA Bank or talk with an adviser,” he said, adding that he expects to see continued adoption of peer-based communication and tailored communications by age group.
Industry providers are taking different approaches as they learn more about digital engagement.
“Even prior to the challenges of COVID last year, participants had already moved online when managing their finances and their 401(k),” said Invesco’s Jenkins. An Invesco survey of over 900 plan participants revealed a majority still indicate work e-mail as their preferred medium, but some ranked personal email very high. This is particularly relevant for a workforce that’s out in the field, he noted.
“One surprise was that text messages and video clips were ranked at the bottom of our survey, even among younger workers,” he said. “The lesson is to use those as supplemental rather than as the main mode of communication on the plan.”