The 2021 List Issue, Part 3: 10 headwinds faced by DC participants in preparing for retirement
While defined contribution (DC) plans are both popular and predominant, they have not yet proven to be successful, as measured by the defined benefit (DB) yardstick of providing employees with a lifetime of sustainable income.
A significant body of research has delved deeply into the projected retirement savings gap in the U.S. Yet for all this valuable effort, little has focused on the gap that matters most to individuals: the gap between the retirement income they want and what they are on track to achieve.
Our DC headwinds list focuses on three areas:
- (1) How does a low-interest-rate environment adversely impact a participant's retirement income?
- (2) What's the long-term impact on projected retirement income when funding sources are interrupted as we saw during 2020.
- (3) How can we build more resilient plan and participant portfolios.
Low interest rates
1. Retirement income goal – DC plan liability
To provide needed liquidity to economies around the world, central banks have reacted to the COVID-19 pandemic by providing fiscal stimulus at an unprecedented rate. In the U.S., the Federal Reserve has set discount rates at 0.25%, and signaled their intent to maintain levels near zero through 2023. This period of protracted low rates will negatively affect long-term investors like pension plans and insurance companies.
But the personal funded status of DC participants will also be adversely impacted. Just like DB liabilities increase as interest rates fall, a DC participant's liability, or the present value of their retirement income goal, also increases. The result is a corresponding reduction in their personal funded status.
Most investment committees spent a majority of 2020 discussing whether they would be required to make additional contributions or increase their allocation to return-seeking assets. Compare that to DC participants, most of whom are likely unable to make additional contributions and probably not likely or willing to assume more investment risk.
2. The impact of interest rates on purchasing income in retirement
As noted by Lawrence Summers, former director of National Economic Council, "Wealth can go up because future income streams go up, or wealth can go up because the discount factor goes down."¹ For that reason, many market observers attribute much of the gains enjoyed by equity investors over the past 20 years to falling interest rates.
To achieve a successful outcome, participants will need to convert their DC and personal savings into an income stream in retirement, which becomes more expensive as interest rates decline. An easy way to see this is that a decline in interest rates translates relatively straightforwardly into an increase in the cost of an annuity.
Table: Cost of $1,000 of retirement income in a falling rate environment
|December 31, 2019||October 31, 2020|
|10-year Treasury yield||1.92%||0.88%|
|Cost of income ($1,000 per month)||$190,920||$215,348|
The result is that as stocks increase in value because interest rates decline, there is little or no real improvement in retirement income.
Interrupted funding sources
3. Suspended employee deferrals
Although the suspension of employee deferrals as a result of unemployment or financial stress may be temporary, the pandemic has the potential to have a long-lasting impact on an already inadequate retirement savings. We use a sample 25-year-old employee with a salary of $75,000 to illustrate the impact of lost savings. For this sample employee, a one-year interruption at age 40 in their salary deferral and match will reduce their final savings at retirement by $60,263, or 2.66%.
4. Suspended employer match
The priority of companies is to keep people employed, so suspending employer contributions to their DC plans has occurred, and will likely be considered by additional organizations. For our sample employee, the impact on savings at retirement for a two-year suspension of the employer match beginning at age 40, would be a reduction of $32,103 or 1.4%.
5. Employee distributions to replace lost income
The Coronavirus Aid, Relief and Economic Security (CARES) Act waives the 10% penalty for premature distribution that would ordinarily apply for withdrawals taken prior to the age of 59 ½. The maximum allowable distribution under CARES Act is $100,000. For our sample employee, the impact on savings at retirement for a $100,000 distribution at age 40 would be a reduction of $542,743 or 23.9%.
Creating more resilient plan and participant portfolios
6. Rethinking core menu design and portfolio structure
Menu design and portfolio construction play an important role in the success of a plan, because selecting the right investment strategy can be overwhelming for most employees. For committees seeking to engage participants and help them achieve better retirement outcomes, using a multi-manager, white-label structure to consolidate and simplify the plan menu is an essential step.
It's also important to develop a hierarchy for where active fee dollars should be spent first, and conversely, where passive management is preferred. How much active versus passive to include in any solution depends upon several factors, such as the return needs of the fund, fee budgets, and the tracking error and cost of the passive alternative. We believe the best plans provide a preference hierarchy for the asset classes believed to be most likely to generate excess returns in magnitude, persistence, and risk-adjusted terms.
7. Use of private securities
DB plan fiduciaries have long understood that creating portfolios with the appropriate balance between return-seeking and hedging strategies most often leads to success. DC clients that offer white label portfolios or custom target date funds should consider incorporating similar strategies to improve the efficiency of their plan's investment options. Although not suitable as a stand-alone option, we believe a competently managed exposure—in a custom TDF or white label fund—to illiquid assets will generate higher returns than comparable liquid assets in many market environments. Because of ERISA regulations, sponsors considering such an option will want to review these issues with counsel.
8. Responsible investing
We recognize the importance of responsible investing and environmental, social, and governance (ESG) issues for our clients. In the coming years, we believe responsible investing will become standard practice for investors. Understanding how ESG factors impact security prices and portfolio structure will be integrated into the entire industry. Be sure to work with a DC provider with an integrated approach.
9. Personalized default options
Off-the-shelf target date funds (TDFs), the Qualified Default Investment Alternative (QDIA) used by most DC plans, are based on an average U.S citizen, rather than specific investor characteristics. While they have clear advantages over earlier best-in-class solutions, such as lifestyle funds, they are only attempting to simplify investment decisions, rather than providing advice on both funding and investing strategies.
On the other hand, managed accounts, which are frequently offered in a DC plan, recommend the savings level and investment allocation designed to put the participant on the path to fully fund their retirement. Just like pension plans are unique to each sponsor, DC participants would likely benefit from the more comprehensive and personalized advice of managed accounts.
However, it may be difficult to justify using managed accounts as the QDIA when TDFs are available at significant discounts.
We believe that committees should challenge their recordkeepers to allow additional competition, and, given the fee compression experienced by the rest of the industry, they should expect a reduction as part of their triennial formal review of their provider. A hybrid approach where participants are initially defaulted into a TDF but are then automatically moved to the managed account as retirement nears could be a solution for those committees concerned about the managed account fees for a full-career employee.
10. Lifetime income solutions for those close to retirement
The primary focus for DC plan sponsors and committees has historically been on helping participants accumulate assets during their working years, with little support provided in retirement. That's like taking an airplane flight only to have the pilot parachute out of the plane just before reaching your destination. We believe the landing gear of a good DC system should be the solutions designed to help participants convert their accumulated retirement balances into a reliable stream of income.
A flashpoint may be on the horizon. The SECURE Act, passed in December 2019, provides a new fiduciary safe harbor for selecting an insurance provider as a distribution option and makes mandatory inclusion of lifetime income projections on participant statements a reality. After many years of discussing lifetime income, we believe that we will finally begin to see more widespread implementation in 2021.
The bottom line
Today's defined contribution participant faces significant challenges in preparing for retirement, which has been exacerbated by the COVID-19 pandemic and related market turmoil. For defined contribution to succeed in preparing participants for retirement, plan sponsors and investment committees should consider changes and improvements that could make meaningful progress in helping their participants reach their personal funded status goal.
¹ Remarks of Lawrence Summers, Would a "Wealth Tax" Help Combat Inequality? A Debate with Saez, Summers, and Mankiw, Peterson Institute for International Economics, October 18, 2019