DC plans wrestle with risk question

Defined contribution plan sponsors are doing more to control investment volatility but many still are grappling with issue of how — or whether — to control or eliminate the biggest post-retirement risk their participants face: income adequacy.

“Risk is the new mantra. Everyone is asking how to define and mitigate or eliminate risk,” said Mark Fortier, senior vice president and head of product and partner strategy, AllianceBernstein Defined Contribution Investments, a division of AllianceBernstein LP, New York.

The financial crisis of 2008-2009 was “another jolt to the system that caused both defined contribution plan sponsors and investment managers to start paying more attention to volatility management, whether at the strategy allocation level or within a particular investment approach,” said Michael Falcon. He is managing director and head of retirement at J.P. Morgan Asset Management, New York.

To date, plan sponsors have concentrated on diversifying their investment offerings, both target-date funds and stand-alone investment option lineups, to provide some downside volatility control during market drawdowns, sources including Mr. Falcon said.

For example, some sponsors have added real return strategies, usually real estate, and hedge funds to provide inflation protection and an uncorrelated return source, respectively, said Kevin Vandolder, a partner at investment consultant Hewitt EnnisKnupp, Chicago.

“The first step DC plan sponsors took in reaction to the financial crisis was to mitigate risk in their target-date funds. Most plan sponsors still are at this stage, still trying to solve the traditional investment risks, like tail risk” and asset class correlations, AllianceBernstein's Mr. Fortier said.

“The next evolution for defined contribution plans is dealing with non-investment risks, the area where traditional investment theory doesn't work. The most important of those risks are post-retirement income volatility and longevity risk, outliving that income stream,” said Mr. Fortier.

“The risk is of calibration, that you won't have sufficient money to retire when you want to,” said JPMAM's Mr. Falcon.

“Everything in defined contribution plan design is outcome oriented,” Mr. Fortier said, noting plan sponsors have to decide whether their preferred outcome is that participants retire with the highest possible balance or the highest possible lifetime income.

One problem with Mr. Fortier's thorny question is that the defined contribution plan industry itself is divided when it comes to what the purpose of a 401(k) plan is.

“The goal of a 401(k) plan is to provide sufficient income in retirement, not to accumulate wealth,” said Anthony Webb, senior research economist, Center for Retirement Research at Boston College, Chestnut Hill, Mass.

“The volatility of retirement income is important, not the volatility of the principal,” Mr. Webb stressed.

Mr. Falcon countered: “A 401(k) plan is first and foremost an accumulation vehicle, designed to take small amounts of money over a long period of time and to pay it all out at once.” He added that he doesn't want to see “too much interest taken off controlling volatility” in the wealth accumulation phase.

Plan sponsors themselves differed in what they said their purpose was in offering a DC plan and what they said was the goal of plan design, according to results of a survey released in October by Towers Watson & Co.

Seventy-four percent said they offered a DC plan to provide “an adequate retirement income at a reasonable age.”

However, when asked for the top issues driving plan design, 46% cited the “workers' ability to retire at a reasonable age and benefit level,” the report said. That response ranked fifth behind remaining competitive with peers (69%), the cost of the plan (63%), retaining and attracting workers (55%), and complying with laws and regulations (47%). The survey allowed for more than one answer.

The survey also found that guaranteed lifetime income distribution options in DC plans remain rare, with only 6% offering one. One percent said they will offer such an option by the end of 2013, while 31% said they are considering it but haven't planned anything. Sixty-one percent aren't considering it.

The top reasons for not offering a lifetime income option were lack of participant demand (60%), administrative complexity (49%) and fiduciary risk (34%).

The consensus of industry observers is that DC plan sponsors slowly, but steadily, are responding with “high income” to Mr. Fortier's question.

“Retirement readiness, the ability to retire with confidence that you won't outlive your savings, is very important to participants,” said Hewitt EnnisKnupp's Mr. Vandolder, noting volatility management post-retirement is essential to maintaining the income stream.

Fully one-third of HEK's 300 defined contribution plan retainer clients are in the process of adding in-plan lifetime income options, Mr. Vandolder said, declining to name those clients.

AllianceBernstein last year assisted United Technologies Corp., Hartford, Conn., in adding a lifetime income option to the 401(k) plans for its salaried and union workers, with total assets of $15 billion. AllianceBernstein now is working with several other large retirement plans to add lifetime income options to their plans. Mr. Fortier said he could not identify these plans until implementation is completed later this year.

The biggest shift coming to the DC plan market will be in-plan income solutions, offered alongside other investment options, agreed Mr. Falcon from J.P. Morgan. But he said that shift isn't likely to happen until the Department of Labor provides safe harbor definitions for an “acceptable level of income in retirement.”

Once those safe harbors have been established, AllianceBernstein's Mr. Fortier predicted more retirement plan sponsors will offer employees the insurance protection of a lifetime-income provision.

“Volatility management is about mitigating risk in down markets and it's as much about behavioral finance as it is about investing. Lifetime-income management is about eliminating the risk by pooling it with an insurance company.

“Defined benefit plans pool away the investment and longevity risk for the individual on a collective level. Lifetime-income options pool the risk for a single individual,” Mr. Fortier said.

Robert Steyer contributed to this story.