The retirement security of defined contribution (DC) plan members is greatly influenced by their saving and investment choices as well as the timing and performance of financial markets. But plan sponsors and trustees still have an opportunity to positively influence the retirement outcomes of their members.
Three areas in which plan sponsors can make the biggest impact on savings growth are investment structure, investment selection and plan design, according to TD Asset Management’s Jafer Naqvi and Nicole Lomax in their article “DC Decisions: What Matters Most for Plan Members?” from the September/October issue of Plans & Trusts.
Among the specific takeaways Naqvi and Lomax highlighted are (1) instituting a multi-asset default option—versus guaranteed rate funds—could greatly benefit plan members; (2) adding private alternatives to a default option can be more impactful than members saving for an additional ten years and as impactful as increasing their contribution rate by 3%; and (3) when feasible, implementing plan design decisions that encourage earlier saving and higher contributions—such as automatic enrollment, member education and/or automatic escalation of contributions—can help members get the most out of their savings and investments.
Historically, many plans have offered a default option of money market or guaranteed rate funds. These low-risk investment vehicles aim to protect plan member savings from the volatility of equity markets.
However, as Naqvi and Lomax note, “In today’s low-interest-rate environment, most plan member interests are not well-served by these low-risk fixed income vehicles because they can present significant shortfall risk to plan members. Member contributions very likely will not experience enough investment growth throughout the 40-year savings horizon, which results in a lower account value at age 65 and shorter capital longevity in comparison with a balanced fund.”
Due to the importance of this decision, plan sponsors should consider setting balanced funds, asset allocation funds and target-date funds as the default options.
Investment Selection: Private Alternatives
Including alternative investments in a DC program is another important decision facing plan sponsors. The authors discuss private alternatives, in which the underlying assets are privately owned and directly sourced, such as buying an office tower or a solar farm.
“Private alternatives can provide a return premium not available with listed alternatives and have demonstrated improved diversification benefits with equities and fixed income,” Naqvi and Lomax wrote. “Defined benefit plans have invested for many years in private alternatives, and our analysis shows DC plans may also have a similar need for these investments.”
The authors found that the diversification and risk-enhancing benefits of private alternatives could improve the expected retirement outcome of a typical plan member up to an additional $110,000, relative to a target-date fund without any alternatives, and could lead to a ten-year improvement in capital longevity if the member continues in the program.
If plan sponsors can’t offer private alternatives as a standalone selection, they can still provide default investment options that incorporate private alternatives into the asset mix.
Designing a plan that encourages earlier savings and increased contributions can have a material impact on retirement outcomes, though the authors note that it isn’t always feasible.
“Many members begin their careers living paycheck to paycheck or are more concerned with reducing their existing debt load,” Naqvi and Lomax wrote. “Alternatively, plan members may be focused on near-term goals, such as saving for a home down payment, allocating funds toward covering the costs of starting a family or furthering their education.”
When earlier saving is possible, however, it can make a big difference. A typical plan member who begins saving at age 25 can accumulate an additional $100,000 to $200,000 compared with a member who enrolls at age 35.
The governance around contribution rates often differs by plan, but the authors found that a typical plan member can accumulate an additional $47,000 to $74,000 with a total contribution rate increase of 1%. A more meaningful impact can be seen from a 3% increase in contributions, which could result in an additional $92,000 to $147,000.
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The following are three important takeaways from the authors’ research.
1. Changing a default option to a balanced fund or target-date fund can have a drastic impact on the amount of savings accumulated when a member reaches age 65 and how long those savings last through retirement.
2. Adding private alternatives to a default option can be more impactful than a member saving for an additional ten years and as impactful as increasing a member’s contribution rate by 3%.
3. Plan sponsor tools such as automatic enrollment and automatic escalation of contributions can help members start saving earlier and saving more, both of which can lead to significant gains in retirement outcomes.
Robbie Hartman, CEBS
Editor, Publications, for the International Foundation
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