'DB'ing' of DC plan default options gains momentum overseas

Expected to gather more defined contribution assets than all other choices combined in major pension markets, the next generation of age-based default investment options will likely be constructed using many more defined benefit building blocks.

Taking a cue from U.S. target-date funds, which are going through a transformation period themselves, default options being launched overseas are increasingly using alternative investments, manager diversification and risk management tools to optimize performance.

At stake is how to better design and implement the asset allocation strategy of default options.

“We think plan sponsors should be putting the bulk of their resources into building a better default,” said Richard Davies, managing director for defined contribution at Russell Investments, New York.

While the U.S. leads globally in target-date fund innovations, other nations are catching up, particularly in capturing the illiquidity premium and using derivatives to lower volatility.

Mark Fawcett, chief investment officer of NEST Corp., London, the trustee group for the U.K.'s national DC plan, said one key focus worldwide is how to incorporate illiquid assets into the investment portfolio.

At NEST, two main barriers exist — cost and daily pricing, Mr. Fawcett said. “Providing that you can manage those two issues, we don't see any reason why we shouldn't invest in illiquid assets to get access to the different risk premiums,” Mr. Fawcett said. NEST issued an RFP earlier this year to hire direct real estate and global REITs managers, and is currently conducting research into how infrastructure could be added to the target-date default fund.

NEST officials are exploring “what is an appropriate proxy between valuation periods” for infrastructure, Mr. Fawcett said. “Because (infrastructure) is not going to be massive part of the fund, any difference (from the true value) will likely be a rounding error. At the fund level, this error will be negligible. We need to make sure that any differences are within an acceptable tolerance level, and members won't be disadvantaged.”

“If we can work through these issues, infrastructure will be the first truly illiquid asset” to be added to the default fund. In the long term, illiquid assets could potentially account for 20% of the portfolio, depending on cost and the relevant risk/return characteristics.

DC risk management is also progressing overseas. At NOW: Pensions, assets are allocated into five dynamically managed risk categories — equities, inflation, rates, credit and commodities. Officials use derivatives to mitigate risk in a return profile that mimics a typical portfolio of 60% equities and 40% bonds but with less volatility. NOW: Pensions puts all participants into one or more of three existing strategies: diversified growth, retirement protection and cash protection, said Morten Nilsson, CEO of NOW: Pensions, a London-based DC pension provider that is owned by the 730 billion Danish kroner ($128 billion) ATP, Hilleroed, Denmark.

“DC plans need to think more like DB plans in managing risk,” Mr. Nilsson added. “The normal pension saver is not investment savvy and does not understand investment risks. As such, default plan design needs to be smarter about investment risk.”

NOW: Pensions doesn't give participants a choice of options because the company operates under the assumption that plan participants shy away from active decision-making. So a 21-year-old, for example, will have all his or her investments in the diversified growth fund at a risk level corresponding to a 60% equity 40% bond portfolio, but invested into five different dynamically-managed risk classes. A 61-year-old will be on the lifestyling model, in which allocations to the diversified growth strategy are gradually shifted into a retirement protection fund that potentially has more exposure to cash. At retirement, the individual's portfolio might have a 20% allocation to the diversified growth strategy.

“We focus on keeping it simple,” Mr. Nilsson said. “We look at what (participants) need, what would get them the desired outcome and getting rid of as much risk as possible.”

In the U.K., where a national defined contribution plan launched in 2012 is expected to boost retirement savings nationwide by hundreds of billions of dollars in the next 10 years, the vast majority of participants will likely funnel their contributions into default funds.

J.P. Morgan Asset Management is considering target-date funds for U.K. plan sponsors. SmartRetirement, its target-date funds for U.S. plans, gained success partly due to a focus on alternatives, consultants said. For example, a 10% risk allocation to illiquid assets is included, of which about 7 percentage points is in direct real estate. Portfolio managers continue to look for illiquid, opportunistic investments to enhance returns, said Anne Lester, a New York-based managing director.

“In maximizing the efficiency of the portfolio, we have a bias toward using as many asset categories as possible,” Ms. Lester said. “We use the same investment diversification methods in DC that we would use for a typical DB client.”

Elsewhere around the world, enrollments in default funds have far outpaced other options in Mexico, Peru, Chile and Sweden, according to the Paris-based Organization for Economic Co-operation and Development.

Sweden's AP7 — manager of the nationwide pension default fund with 125 billion Swedish kronor ($19 billion) in assets — moved to an age-based approach in 2010, according to information provided by the fund at the time. The fund is heavily dependent on the equity risk premium obtained from a diversified range of sources including long/short hedge funds and private equity until age 55, and then gradually ratcheting up government bond exposure at a rate of about 3% annually until age 75. At that time, the individual's exposure to bonds is about one-third of the entire portfolio.

In the U.S., target-date funds — the most popular choice of the three qualified default investment alternative available — attracted 63.3 cents for every dollar that flowed into DC plans nationwide in 2012, according to data compiled by Callan Associates Inc.

“Within the next 10 years, between 60% and 80% of the total DC assets for most U.S. plan sponsors will likely be in default funds,” Russell's Mr. Davies said.

One major development emerging in the U.S. is the emphasis on income replacement at retirement as part of the broader plan design — a move that will significantly impact default options, managers and consultants said.

DC plan executives are asking, “What are the chances that a particular custom target-date framework can achieve a specific goal?” said Joseph Healy, senior vice president at AllianceBernstein LP, New York. One example: targeting income replacement of 80% through a combination of the defined contribution plan and Social Security, Mr. Healy said.

He said plan executives are “no longer as concerned about the last five years of performance.”

On asset allocation, DC plan officials might instead compare stochastic models to estimate the probability of certain targets to be achieved based on population-specific assumptions, sources said. A shift toward a salary replacement target has significant implications for investment strategies and the manager structure itself.

“A few organizations have really taken on some great responsibilities, recognizing that DC — going forward — is not going to be what it has been in the past and they need to revamp the structure,” said David O'Meara, senior investment consultant at Towers Watson & Co., New York. “It's not supplemental anymore; it is the retirement income.”

Deluxe Corp., Shoreview, Minn., is one U.S. company where executives have stepped up efforts to reach a certain salary replacement level.

Deluxe officials had designed the custom target-date funds with a 90% income replacement ratio in mind for a participant with a full career at the firm, according to Mark Kelliher, senior manager of retirement plans. As of March 31, about 71% of the participants in Deluxe's $1.4 billion 401(k) plan use target-date funds. They account for about 40% of total participants' assets.

“The asset allocation glidepath that we designed is part of the feature that we think needs to be in place in order to attain a 90% goal,” Mr. Kelliher said in an e-mail.

He said the goal is more likely to be attained if participants adopt other recommendations such as “a deferral schedule that is at least as aggressive as our scheduled auto-escalations.” Deluxe automatically increases participants' contribution rates at 2% annually up to 15% of pay. The company received an Innovator Award, sponsored by Pensions & Investments and the Defined Contribution Institutional Investment Association, in 2012 for its plan design.