Finding innovation in defined contribution (DC) plans is the existential question that continues to challenge plan sponsors, managers, and consultants to do better. While the goal may be to help more than 80 million participants sufficiently save for retirement, we are not there yet.
Central to any solution is ERISA, the 1974 landmark legislation aimed at preventing another Studebaker-like insolvency. Though both DC and defined benefit (DB) plans are governed by ERISA, they are managed in fundamentally different ways—the obvious difference lying in who assumes funding risk. However, common to both is the concept of acting prudently and for the exclusive benefit of plan beneficiaries. Paradoxically, what may be prudent for a DB sponsor may not be prudent for a DC sponsor—and yet the interest of the plan beneficiary is analogous.
Though things have improved dramatically since the passing of the Pension Protection Act (PPA) 10 years ago, DC sponsors have a much more limited tool kit. We’ve seen large-scale development over the last decade in target-date funds, auto-enrollment, and auto-escalation, but DC still often falls short of its aspiration to deliver adequate income in retirement. Are plan sponsors trying to solve the wrong problem?
There are also a number of perverse incentives that drive DC plan sponsors’ behaviors away from their goals. The behaviors are not irrational. In practice, being a prudent fiduciary is often synonymous with using good judgment and acting within established norms. But what if established norms do not represent good judgment? What is preventing investment committees from adopting DB plans’ approaches to solve obvious problems with DC plans?
For the answer one must, unfortunately, go back to what it means to be prudent. Stepping outside of peer-defined norms is risky. In essence, ERISA rewards herd behavior. When DC plan sponsors do innovate, their reward is often litigation.
The best example is Intel. As far back as 2009, Intel began to invest in hedge funds and private equity in its custom target-date funds and global diversified funds. When those investments soured, Intel faced a lawsuit claiming that it “not only deviated greatly from prevailing asset allocation models… but also exposed the plans and their participants to unreasonably costly and risky investments in hedge and private equity funds.” Wither innovation.
So what would motivate a plan sponsor to address the needs for income in retirement? Ironically, it would take a combination of both regulation and public policy. One has to look no further than the PPA and the rapid adoption of both the QDIA [qualified default investment alternatives] and auto plan features for a strong precedent that this could work. The Department of Treasury has even signaled the importance of having a source of income in retirement with the creation of the Qualified Longevity Annuity Contract (QLAC). However, absent a prescribed safe harbor from the Department of Labor, insurers and asset managers are reticent to build products they know that DC plan sponsors will be reticent to adopt.
Still, innovation exists. A variety of insurers have been offering in-plan guaranteed minimum withdrawal benefit annuities through 401(k) plans marketed to small- to medium-sized employers. Though available, the cost and complexity of the products has hindered adoption. But the concept of lifetime income has appeal, at least to one large employer.
Most notably, United Technologies (UTC) has incorporated annuities into its custom target-date funds, allowing employees to take investment, interest rate, and longevity risk off the table beginning at age 48 by purchasing units of a pool, managed by three insurers, of variable annuities in the plan. If there is market appreciation, the participant gains through the exposure to equities. If the market declines, the participant is protected through the guaranteed rate of return and principal protection underwritten by the insurers. Though UTC has not faced litigation as of yet over its innovative approach to offering a retirement income feature to its 401(k) plan, other plan sponsors have failed to follow its lead.
When ERISA was first passed, there were no participant-directed 401(k) plans, and yet it is the governing statute, thus suggesting that ERISA itself is organic and ever-evolving. While UTC, may not have become a pied piper of DC innovation, one can still argue that DC plan sponsors have come to an important inflection point: one that requires innovation from plan sponsors, investment managers, and consultants alike. The DC marketplace is quickly embracing “outcomes” as the unit of measure of plan and participant success. Governance processes are also beginning to define similar measures of success. In time, DC plan sponsors are likely to face the risk that their plans’ outcomes are simply not adequate, and thus their action to that date will be deemed imprudent.
Looking to pension management as an analog, one can see how innovation served as a means to manage a similar risk. Accordingly, DC sponsors, managers, and consultants need to embrace this risk in the same manner. In time, the danger of not doing may in fact be greater than doing so.
Josh Dietch is head of retirement and institutional for Strategic Insight, Chief Investment Officer's parent company.