DC plans better prepared for downturns

Defined contribution industry experts say many DC plans are better equipped to deal with the next economic downturn than they were in 2008.

That's because they are doing more of what they should have been doing all along.

That means seeking multiple ways to achieve diversification, such as reducing allocations to company stock, trimming reliance on equities, reviewing target-date fund glidepaths and exploring alternative investments. It also means enhancing education efforts so participants are thinking about retirement readiness, rather than just asset accumulation.

Consultants and providers say plan executives are paying more attention to the potential impact of future inflation, and the executives also are simplifying investment menus without reducing diversification.

“We see investment committees taking a harder look at their lineups,” said Jeanne Thompson, vice president of market insights for Fidelity Investments, Boston. “In the old days, it was anything and everything. Now, it's three tiers — target-date funds, core funds and self-directed brokerages. They want to make it more digestible. When you have too many choices, you can't make a decision.”

Among Lori Lucas' clients, the major question is, “Where are the gaps in my fund lineup?” said the Chicago-based executive vice president and defined contribution practice leader for Callan Associates. “They are focusing on the next big concern. Inflation is the No. 1 concern.”

Stephen P. Utkus, principal and head of Vanguard Inc.'s center for retirement research in Malvern, Pa., said Vanguard's clients are asking about whether they have adequate inflation-protection options and whether their target-date funds and glidepaths are appropriate for their participants.

DC experts also say that plan executives aren't looking in the rearview mirror at the economic crisis of five years ago. The stock market crash of 2008 “is not the first question we hear” when talking to clients about menu design, Mr. Utkus said.

“You don't want them to forget 2008, but you don't want them to manage their plans looking to 2008,” Ms. Lucas said.

“They're trying not to fight the last battle,” said Josh Charlson, senior mutual funds analyst and target-date strategist at Morningstar Inc., Chicago. “They're looking ahead.”

In broad terms, DC plan participants' portfolios are more diversified, with allocations to company stock declining, for example. And while plans' allocation to inflation-hedging options is still small, the strategies are attracting more interest.

Plus, some surveys show overall equity investments are deceasing, although equities remain the dominant category. And, of course, the use of target-date funds has grown significantly.

Fidelity has found that over time, participants who invest in only one DC plan option are increasingly choosing target-date funds or balanced funds. Among those single-option investors, 46% selected a target-date fund or balanced fund at the end of 2007, Ms. Thompson said. The percentage jumped to 76% at the end of last year.

Some investment-strategy and plan-design changes were prompted by the Pension Protection Act of 2006. For example, PPA enabled target-date funds to become qualified default investment alternatives, setting in motion DC plans' making these funds the dominant QDIA today. The PPA's wording governing company stock has contributed to its diminishing role.

Many of these changes, in aggregate, have continued or accelerated since the economy and stock market boomed in 2007 and busted in 2008 and early 2009.

A Vanguard survey of DC plans for which it is record keeper shows target-date funds accounted for 17% of total asset allocation last year, compared with 5% in 2007.

Total equity accounted for 66% of asset allocation among its clients' plans last year, down from a peak of 73% in both 2006 and 2007. During weak markets, some non-target-date fund participants moved some money out of stocks, Mr. Utkus said. Although the stock market recently hit highs that surpassed those in 2007, “we are not seeing participant equity exposure at that level,” he said.

Vanguard's research also shows a steady decline in the asset allocation of company stock, reaching a low of 9% in 2011 and 2012 vs. 11% in 2007.

Callan recently reported that target-date funds are growing at such a rate that they could become the biggest allocation component within five years. The target-date fund allocation was 15.7% for the quarter ended Dec. 31, second only to domestic large-cap equity at 23.3%.

According to a Callan quarterly index, total equity reached a peak allocation of 70.5% in December 2007 and a low of 55% in September 2008. By the end of 2012, the equity allocation was 62.8%. “We're seeing consistent flows out of large-cap equity,” Ms. Lucas said.

Some target-date fund families have made changes, too, adjusting glidepaths to be more conservative in the funds for people near or at retirement, Morningstar's Mr. Charlson said.

In 2008, many target-date funds — especially those for people near retirement age — were hurt both by the stock market drop and by bond portfolios containing lower-quality securities. “Now, the credit quality has improved,” he said.

Target-date funds remain a balancing act, he said. In the past five years, for example, investors in many of the most aggressive funds “made their money back and more if they waited it out.” In a downturn, the target-date series with the most conservative glidepaths, and a low equity point for people near retirement, will hold up the best, Mr. Charlson said.

“We have done a number of target-date fund searches for clients who weren't comfortable with their equity allocations,” said Sue Walton, Chicago-based director at Towers Watson Investment Services. Some chose a more conservative glidepath; others picked passive funds over active ones. Some chose a “to” fund — in which the equity component stays fixed after the retirement age date — vs. a “through” fund, in which the equity allocation declines after the retirement date.

As for alternative investments, their cost “is probably the biggest hurdle,” said Josh Cohen, Chicago-based defined contribution practice leader for Russell Investments. “We are in such a fee-sensitive world.”

The most palatable way to add alternatives — such as real estate, commodities and infrastructure — to a DC plan menu would be through a bundled portfolio or as a component of a target-date fund, Mr. Cohen said. Although he doesn't have specific numbers, “we do see common usage of real assets both in target-date funds and real assets bundled solutions.”

All of the changes won't make much difference if participants don't understand their value. Experts say that although plans are offering more education aimed at retirement readiness — personal savings, Social Security, retiree medical and pension plans as well as DC accounts — there's more to be done.

“There's an increased focus on education even though employers are leery of putting anything out there that might be considered advice,” said Jacob O'Shaughnessy, an adviser at Arnerich Messina Inc., Portland, Ore.

“Sponsors and providers are getting better at making surgical strikes at an issue, rather than carpet bombing” with their education campaigns, said Robert Benish, interim president and executive director of Plan Sponsor Council of America, Chicago. “Targeted communications within plans is much better at identifying key (demographic) subsets that need special help.” n