By Charles E. Haldeman Jr.
With the Pension Protection Act now signed into law, investment management companies have a major opportunity to help prevent a pending retirement crisis. As many have observed, the act implicitly confirms that most American workers will have to depend on their defined contribution plans to help achieve financial security in retirement, as the stringent requirements are likely to hasten the elimination of defined benefit plans. Working closely with employers and other DC plan sponsors, investment managers must create better tools to help plan participants close the retirement savings gap, diversify to increase returns and reduce risk, as well as manage their assets in retirement so they don't outlive their money.
In short, we have to make sure DC plan participants have access to investment tools similar to those that have been used successfully by defined benefit plans. Why? Because historically DB plans have achieved greater investment success than 401(k) plans. The Retirement Services Roundtable reports that between 1995 and 2005, the average annual return for DB plans was 7.7%. For the average employee in a DC plan, it was 6.4%. That 1.3-percentage-point gap could hypothetically result in a $700,000 savings shortfall for an American worker who has invested $10,000 per year over the span of a 40-year career.
The reasons for this discrepancy are based largely in traditional differences in investment behavior between institutions and individuals. Institutions typically invest according to a long-term strategy, with goal-oriented asset allocation that balances risk and return, using diversification and other techniques to manage risk. By comparison, individual investors often procrastinate when it comes to investment decisions. In fact, 30% of American workers who are eligible to participate in DC plans have not enrolled. And those who do participate tend to save too little too late, and react to market movements in knee-jerk ways that cause them to buy high and sell low. They are often either too conservative, keeping all of their assets in the safest options with the lowest returns, or too aggressive in chasing the highest returns without understanding the risks. They may also put too many eggs in one basket, such as investing solely in their employers' stock.
The Pension Protection Act seeks to change the behavior of individual plan participants in two major ways. In allowing employers to automatically enroll workers in the plan, and forcing participants to specifically opt out rather than encouraging them to opt in, the act intelligently removes procrastination as an excuse for not saving. And by making it safer for employers to add an advice component to their plans, the act will promote better investment decisions, made with the help of professionals, than most participants have made to date. Investment management firms experienced in serving both institutional and individual investors are well positioned to make other changes that will work with these provisions of the act to yield even better results for plan participants.
First, to close the savings gap, we need to bring the same thinking and creativity to DC plans that we have historically brought to DB plans. Shifting the burden of saving to the individual level from the organizational level does not mean the math of saving for retirement has changed. From an investment management perspective, the switch to DC from DB is simply a change of plan structure. DB and DC plans each have the same goals: to generate enough income for their participants to retire. We need to offer DC plans total-return-oriented investment solutions that pursue higher returns without significantly higher overall risk. The same people should manage money for both kinds of plans, so that the same long-term-oriented and sophisticated investment management expertise is put to work for employees regardless of plan type.
Second, to improve the diversification of participants' assets, we need to emphasize the benefits of using pre-diversified asset allocation funds as the primary default option in plans. Putnam research shows that a good asset allocation mix is second only to the savings rate in constructing a successful retirement portfolio. Asset allocation funds, structured according to risk tolerance ("lifestyle" funds) or age (lifecycle" funds) are the best default option for automatic enrollment. Typically these funds rebalance automatically, requiring no action on the shareholder's part to keep the allocations in line. They also encourage investors to hold them for the long term because their inherent diversification removes some of the volatility that can cause participants to change funds if returns falter. A recent DALBAR study shows that for the 20 years ended Dec. 31, 2005, investors held asset allocation funds for an average of 4 years, compared with only 2.9 years for equity funds and 3.2 years for fixed-income funds. And while four years represents the longest retention in this sample period, keep in mind that asset allocation funds were a relatively new concept within this period. Going forward, we think that it is likely that many participants would actually hold these funds for their entire career.
Investment management firms have not yet done all we can do to effectively serve the growing number of DC plan participants, now 52.8 million. In the past decade, many focused their positioning too much on short-term performance at the expense of long-term planning and adequate diversification. The Pension Protection Act gives us a great chance to be part of the solution in helping more Americans enjoy financial security in retirement. I challenge the industry to join us in working with DC plan executives to reshape the retirement landscape.
Charles E. "Ed" Haldeman Jr. is president and chief executive officer of Putnam Investments, Boston.