The defined contribution plan market has mushroomed in the past 15 years. Defined contribution plan assets in the corporate sector now exceed the total of corporate defined benefit plan assets. Few would have predicted such a runaway success for the defined contribution experiment when it first was legislated two decades ago. Yet the high profile achieved by these plans is reinforcing the need for reform in several critical areas.
For example, although participants have become more sophisticated and their expectations of service providers are correspondingly greater, the reality is that the cost burden of plans is still being shifted toward these individual investors. This cannot continue if the defined contribution market is to remain competitive with other forms of retirement savings.
I believe this market will undergo quite dramatic change in the next decade as it loses its retail bias and adopts a more institutional structure. Specifically, this implies the following:
* Downward pressure on fees, away from relatively high retail levels.
* A plan structure more reflective of defined benefit plans, both in its wider choice of investment options and its rigorous selection and monitoring of managers.
* A reduced reliance on mutual funds as the automatic investment vehicle of choice and wider use of other vehicles such as commingled funds and separate accounts.
* More cooperation between treasury and human-resource staff in the decision-making process, as the treasury function becomes increasingly involved in defined contribution plans.
* An even greater emphasis on participant education, as plan sponsors recognize the potential liabilities that might arise if they do not pay more attention to this area.
SQUEEZE ON FEES
Less dependence on mutual funds would be an obvious way of cutting defined contribution plan costs, since total expense ratios within retail mutual funds are high by any standard. However, there is another, less overt factor at work that effectively increases costs to the participant. Now, even the large mutual fund complexes providing services on a bundled basis are compelled to include non-proprietary funds in their offerings to the plan sponsor.
To offset the subsequent revenue loss, these bundled providers typically demand an average of 25 to 35 basis points in fees from non-proprietary mutual funds in exchange for participation in their clients' plans. This means the investment management component of the bundled package is effectively subsidizing most of the cost of plan administration. But why should participants be assessed for these additional fees? At the very least, the overall pricing of bundled service providers should be made more explicit.
DEFINED BENEFIT DISCIPLINE
The defined contribution market still has much to learn from its defined benefit counterpart, even though it has evolved from the early days of limited investment options and quarterly valuation. In line with defined benefit practice, large defined contribution plan sponsors now typically offer 10 investment options, and daily valuation is the norm. I believe the number of options will rise still further, to 15 or so, as sponsors add funds in the aggressive/small-cap and international/global sectors.
A very distinct change in defined contribution plan structures will take the form of more cost effective investment vehicles, and a move from mutual funds as the automatic vehicle of choice. Already, some large sponsors have created a very effective way to offer defined benefit managers to defined contribution plan participants through unitization, which eliminates the expensive retail fee structure implicit in such plans. Unitization allows participants access to investment managers they would otherwise be unable to reach -- at lower cost.
BIGGER ROLE FOR TREASURY
Changes such as these are being driven by the treasury function, which will become increasingly involved in decision-making at defined contribution plans alongside human-resource staff. Treasury specialists are trained to assess future liabilities of all kinds and sponsors are becoming clear as to the liabilities that might arise if they fail to meet their principal obligation to participants. I define this as providing a competitive plan with full fee disclosure and scrupulous due diligence of investment managers.
True, defined contribution plans do shift the financial responsibility for retirement planning onto the shoulders of individuals. But sponsors still have certain duties to carry out, including manager evaluation -- both quantitative and qualitative -- and investment education, which presents one of the greatest challenges, as well as one of the biggest potential liabilities.
FIGHTING INERTIA
Effectively, a defined contribution plan is only as good as it is communicated. The number of investment options is less important than how clearly sponsors communicate to participants exactly what they are investing in. Yet until now, sponsors generally have been reluctant to spend more on education, especially in light of their concern that they might be perceived as giving investment advice, not just information.
Inertia among participants has been another restraining factor and remains a persistent characteristic of defined contribution plans. In my experience, individuals may be prepared to experiment with future contributions, but they shy from changing the investment mix of existing balances. Although daily valuation has given participants the opportunity to switch balances -- with the danger of creating "short-termism" -- evidence shows that this opportunity is often ignored.
Still, individuals are clearly seeking financial advice. Financial planners will have a major role to play in future defined contribution plans. Sponsors have a responsibility to encourage this development. They also should make use of technology to segment plan participants and target specific communications programs to specific groups. The Internet will have a big influence on how sponsors educate participants.
Of course, none of these changes will take place unless initiated by plan sponsors, who do face an unenviable dilemma. Cheaper pricing is clearly desirable but the maintenance and improvement of systems capability -- another duty to participants -- is increasingly expensive. I believe change is inevitable and the defined contribution landscape even three years from now will look very different.
Ruth Hughes-Guden is a principal at Morgan Stanley Asset Management Inc., New York.
