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Preparing for retirement has seldom been so difficult for so many people. The past 10 years have seen three pension crises as markets have repeatedly slumped and interest rates have gone through extended lows. The result: Older workers who participate in 401(k) or other defined contribution plans have watched their portfolios stagnate and gyrate, leaving them uncertain when they will hit the “number” at which they can retire with confidence.
Meanwhile, companies sponsoring traditional defined benefit plans find themselves in a curiously similar predicament. Seeking to reduce the volatility that pension fund accounting can bring to their balance sheets—especially as the Pension Protection Act’s tight funding requirements take hold—many would like to lean more on fixed income-heavy strategies that minimize risk and produce a more predictable stream of income. But with interest rates dragging, putting the two parts of that equation together has not been easy.
In both cases—individuals investing through 401(k)s and employers sponsoring defined benefit plans—the goal is the same: generate enough return to meet anticipated retirement costs, with as little risk as possible. To get there at a time when markets are being less than cooperative, plan sponsors must change the way they operate, say consultants who work with companies offering both types of retirement benefit.
Companies that want to “de-risk” their defined benefit plans don’t have the luxury of smoothly switching to a liability-driven investment model, given low interest rates, notes Arthur Noonan, partner and senior retirement consultant at Mercer. Instead, companies need to take a more opportunistic approach. “The normal thing is to have quarterly meetings to evaluate the investment portfolio,” says Noonan. “Our belief is [that] this is not responding quickly enough.” Instead, CIOs and executives in charge of the plan, or their outside managers, need more discretion to “de-risk as the plan hits certain numbers.”
ING Investment Management, for example, advocates a “dual portfolio” approach in which one portion of the plan follows a liability-driven strategy while the rest is geared to generate maximum income. Over time, the two portions are rebalanced to reflect an aging group of plan participants and, accordingly, a lower risk tolerance. Bas Nieuwe Weme, head of institutional sales at ING, likens the strategy to the lifecycle or target-date approach often used in 401(k) plans. “In the past, people did asset-liability studies and adjusted their equity and fixed income allocations accordingly. Then they extended duration and hedged out some of the risk,” Nieuwe Weme notes. Following the dual portfolio approach, plan sponsors would instead “sit down with their asset managers and consultants to work a glide path for the plan into their investment policy document.”
Controlling pension risk extends to the size and structure of the plan itself, Noonan argues. Sponsors should also consider shrinking their plans by settling some liabilities with annuity conversions and lump-sum payouts, for example, or converting from the standard, final-average-pay benefit formula to a career-pay structure, which ties benefits more closely to the length of time served with the employer. The goal is not to replace the defined benefit plan, which may still be an important employee attraction and retention tool at a time when workers are becoming more concerned about retirement security, says Noonan, “but to scale it back—make it the core benefit rather than the sole benefit, putting more emphasis on the 401(k).”
By the same token, the job of the executive in charge of a company’s 401(k) needs to become more like that of the CIO of a defined benefit plan, says Nieuwe Weme. For companies that want to help their employees manage risk and reach a clear asset goal at retirement, ING advocates target-date funds that are allocated among a range of asset classes much the way defined benefit plans are.
ING argues against bundling funds with one or two providers, and suggests instead that the sponsor should adopt an actively managed, open-architecture approach, which stresses finding the best run and lowest cost funds. The policy of broadly diversifying the overall portfolio also allows the sponsor to include more aggressive funds not typically found in defined contribution plans, such as real estate and emerging market funds. The result is a structure that requires more active monitoring and decision-making, either by the employer itself, by its consultant, or by a target-date manager selected for the task.
Target-date funds have been around for some years, but this “customized” approach is becoming more popular, says Nieuwe Weme, citing a survey that showed 37% of plans expect to be actively allocating between funds in a target-date portfolio in 2018, as opposed to just 17% in 2008. Interest is penetrating beyond the largest plans as well, he says, noting that two years ago most sponsors offering customized target-date funds had more than $1 billion in assets, while today, plans with as little as $250 million are using the structure.
One reason that both defined benefit and 401(k) sponsors need to manage their plans more actively, says Noonan, is that they each need greater predictability. Defined benefit sponsors want to eliminate unanticipated volatility. Companies offering 401(k)s, meanwhile, need the plan to serve them better as a workforce management tool. “Defined benefit plans sent a very clear message when the employee was supposed to leave the company,” Noonan says. “Defined contribution plans don’t— except through the market.”
Managing the 401(k) to produce a “drive path” toward a desired asset accumulation at retirement can help to correct this, Noonan argues, if it’s combined with greater emphasis on participant education and awareness. “Automatic enrollment and auto escalation are fine, but the employee is still passive. You still need to send an effective message to ‘put more in.’”