DB features increasingly in DC plans

The biggest shift in pension plan design — especially in the U.S. — is the focus, increasingly, moving defined contribution plans back toward defined benefit features.

The change is more by evolution than revolution, with the goal of creating lifetime income, rather than creating wealth — which has been the focus for many years.

One key evolutionary move is that DC account assets should stay in the retirement plan after a participant retires. It might not seem like a big change, but it can have a significant impact on the retiree's costs and help the plan as well.

Trends in plan design aim to expand coverage and improve outcomes by shifting decisions away from participants, while avoiding what one pension expert called wealth transfers from future generations to the current generation.

The features seek to address “some of the challenges faced by defined contribution (participants and sponsors): inadequate planning and goal setting,” said Susan Czochara, senior vice president and managing director for defined contribution solutions, Northern Trust Asset Management, Chicago. “As we see baby boomers retiring, we are starting to see the ineffectiveness of the transition to retirement in a defined contribution structure.”

Key defined contribution design features that incorporate these trends include:

nautomatic enrollment designed to expand coverage;

nautomatic escalation designed to raise contributions to levels to produce better outcomes in meeting retirement income goals;

nautomatic rebalancing to keep participants on track with their risk tolerances and return objectives;

ntarget-date funds designed to determine age appropriate asset allocation for participants;

nmanaged accounts designed to customize asset allocation for participants; and

nlifetime income options designed to generate a guaranteed payment for the life of a retiree.

“401(k) plans were designed as supplemental plans really to create wealth and have not evolved to fill that void of targeting monthly income and specifically guaranteed income” as defined benefit plans would do, said Tim Walsh, managing director of investment services at TIAA-CREF, Boston.

In terms of setting contribution levels, investment mix, rebalancing allocations and withdrawing assets in retirement, “we are finding participants just aren't doing that” adequately, Ms. Czochara said.

Defined contribution plan executives are moving to address these shortcomings.

“Employers are more and more doing the thinking for employees (such as) with target-date funds, auto enrollment, auto increases (in contributions), things of that nature,” said Kevin Wagner, Detroit-based senior retirement consultant with Towers Watson & Co.

The features take their inspiration from the defined benefit plan model of sponsors enrolling all employees and sponsors contributing at levels to have the necessary funds to pay projected benefits as well as sponsors paying out benefits in the form of annuity payments for the life of the participants.

“For defined contribution plans to be an effective retirement savings vehicle, there has been recognition ... auto features need to be put in place,” Ms. Czochara added.

Many “plan sponsors have not adopted auto escalation,” said Jeff Eng, New York-based director, retirement income solutions, Russell Investment Management Co., Seattle. “We know from most research ... most plan participants are undersaving to be able to meet their retirement income needs.”

“Auto increases in contributions make total sense,” said Keith Ambachtsheer, director of the Rotman International Centre for Pension Management and adjunct professor of finance, at the Rotman School of Management, University of Toronto, and founder and president of KPA Advisory Services Ltd., a Toronto-based strategic consulting firm to pension funds and other asset owners. “Auto enrollment makes total sense” as well as providing for some lifetime income options in the decumulation phase when participants retire, he said.

Government has begun to take a more active role to expand workplace retirement plan coverage and improve outcomes, all through defined contribution programs, said Gordon L. Clark, director of the Smith School of Enterprise and the Environment, Oxford University.

The U.S. Department of Labor's Employee Benefits Security Administration is considering a rule to require participant statements to include an estimated projection of the lifetime stream of payments to retirement savings data, in addition to the current total account balance that statements include.

To expand coverage, the United Kingdom and Australia have mandatory enrollment and mandatory contribution requirements, although mandatory features would face a tough sell in the United States, Mr. Clark noted.

“Where the convergence is going globally is toward recognizing that (defined contribution) plans should offer a lifetime income option,” Mr. Ambachtsheer said.

TIAA-CREF's Mr. Walsh said that to improve outcomes, defined contribution “plan design should really ... target monthly income in retirement for participants as the goal. ...

“The way most 401(k) plans are designed today ... is really about creating wealth, which ... is misguided,” he said.

“Plan design, for fiduciaries, should really be about target income.”

“For most participants a portion of that monthly income (in retirement) should be guaranteed for life to protect against longevity risk,” Mr. Walsh said. “That's really the biggest risk in retirement.”

Corporate defined contribution sponsors can learn from TIAA-CREF's experience with 403(b) plans, which is the bulk of its business, Mr. Walsh said. While 403(b) plans are defined contribution plans, they “were really designed as the core retirement plan from the beginning” and “included annuities that targeted monthly income in retirement” unlike 401(k) plans, which were originally designed as a supplemental plan to defined benefit plan coverage.

Some 84% of defined contribution participants surveyed by TIAA-CREF earlier this year said “having a guaranteed monthly payment in their retirement years is important,” Mr. Walsh said. “Yet only 14% of them have taken steps to ensure a lifetime income.”

It is an evolutionary attitude, Mr. Walsh said. “It's not that they don't want a big bucket of money,” he said. “Of course they do. But their priority is making sure that they have that guaranteed monthly payment in retirement as the foundation.”

From a design perspective, sponsors can help participants improve outcomes by incorporating the auto features to boost savings, Mr. Walsh said. In addition, “offering access to specific advice is critical” by sponsors in forms designed to meet participant comfort levels, ranging from online tools to face-to-face engagement.

Participants “want more help from their employers,” Ms. Czochara said. “They want more guidance to help them save (and invest) for retirement.”

It can lead to a “behavioral change,” Mr. Walsh said. “What we've found is participants who save in annuities, they are much more likely to actually annuitize ... at least a portion of savings in retirement) in the form of some type of lifetime benefit.”

In “plan design today, the investment option that gets most of the flow is typically the default option,” which for most plan sponsors is a target-date fund, Mr. Walsh said.

A Securities and Exchange Commission study in 2013 found 64% of participants “think target date funds include guaranteed income” at retirement, Mr. Walsh said. “They don't.”

The EBSA issued guidance enabling plan sponsors to include a guaranteed income as part of the target-date fund. In addition, the Department of Treasury issued regulations to encourage use of annuities in defined contribution plans.

In response to the Treasury rules, MetLife Inc. in May launched a qualifying longevity annuity contract for the defined contribution market.

TIAA-CREF is beginning to offer such an option as well, said Mr. Walsh, adding a client has begun using it this year. He declined to identify the client.

The EBSA guidance for target-date funds to add a deferred annuity option “takes away some of the fiduciary liability and relies on (participant) passive behavior,” said Robyn Credico, Arlington, Va.-based national director of defined contribution consulting, Towers Watson.

Ms. Czochara said, “We found that participants would welcome, not resent, a stronger guiding hand from” plan sponsors.

Plan design also is moving to simpler menu of investment fund options for participants, Ms. Czochara said.

Some “70% of participants are open to a menu that consists of about six options,” that is, a set of target-date funds and five fund options. “It will help the silent majority of participants who are unadvised (on selecting investment allocations) to make better decisions as they invest for retirement,” she said.

To steer participants to better investment allocations, some plan sponsors are re-enrolling all participants into the qualified default investment alternative, usually a target-date fund, Mr. Eng said, although he didn't have statistics on the enrollments.

“Because of participant inertia,” participants tend to stay in the QDIA, Mr. Eng said.

Mr. Eng believes a managed account — which in addition to target-date and balanced funds is one of the three permissible QDIAs — will become dominant.

Managed account providers, which are fiduciaries, customize allocations for each participant, based on an individual's characteristics, to improve outcomes, Mr. Eng said.

Not many sponsors used a managed account approach. “But in terms of being evolutionary ... managed account solutions is the next (leap) in QDIA investing, especially in the large plan space,” Mr. Eng said.

As part of their plan design sponsors should encourage participants to keep assets in the plans after they retire.

For them, sponsors might tailor investments options most appropriate for retirees, Ms. Czochara said.

“It is a win-win (for plans sponsors and participants) to keep assets in the plan,” Ms. Czochara said.

“From a participant standpoint, they have access to institutional-based solutions, which are priced institutionally” and have plan sponsor fiduciary oversight.

“From the plan sponsor standpoint, they're able to maintain scale, which we think is going to become critical especially for some of those plans that have a large portion of their population that is looking to retire,” Ms. Czochara said. “It can change their buying power in terms of negotiation of ... institutionally based cost solutions.”

Keeping track of defined contribution retirees to continue their access to assets in the plan is an administrative challenge for plans sponsors, Ms. Czochara said.

But saving more won't help without including design features to improve outcomes, said Mr. Wagner.

Prudential Financial Inc. offers a guaranteed lifetime income option within defined contribution plans of clients that has attracted $1.7 billion in assets, said Srinivas D. Reddy, senior vice president, head of full service investments, Prudential.

The option guarantees a lifetime withdrawal benefit of 5% of a participant's assets per year. The assets remain invested in the plan. Should a participant's assets run out in retirement, Prudential continues to provide the benefit under the guarantee for a lifetime. Participants, however, remain in control and can withdraw at any time, taking their remaining assets without penalty.

Mr. Eng said: “Lifetime solutions have a place in defined contribution plans but it's too early to tell what the right solutions will be and how it should be appropriately implemented. But plans sponsors should be talking to consultants ... about” it.