What will DC plans look like in 2025?
In a post-defined benefit (DB) world, defined contribution (DC) plans – historically only used to supplement a monthly pension – have largely failed to prepare U.S. workers for retirement. This leaves those who rely on Social Security as their primary benefit and only source of guaranteed income vulnerable and may also adversely impact employers. Delayed retirement creates workforce management issues because employees facing financial stress often come to the workplace in poor health, may be disengaged and are blocking younger workers from advancing. One recent survey shows 93%¹ of plan sponsors agree that they should be responsible for the retirement preparedness of their employees, which may be an indication that employers are beginning to understand their exposure to this issue.
We believe that, by 2025, more employers will adopt some of the characteristics of the most successful pension plans to help put them on a path to create a fully funded retirement income stream for participants. In this blog, we discuss changes we hope will soon become mainstream. To set expectations, we have assigned probabilities that such changes will be incorporated by 2025, where 1=low probability and 5=high probability. Our focus is on the benefits of updating investment governance structures, the need to increase savings to better fund these future "liabilities" and the importance of using more efficiently managed portfolios to increase the likelihood that employees will have successful retirement outcomes.
Updating investment governance
DC plans are now the sole source of retirement income for millions of U.S. citizens; however, committees have been slow to adapt their governance. Still today, most are primarily focused on benchmark-relative performance, with little time devoted to overall strategy. Research by Ambachtsheer, Capelle and Scheibelhut² suggests improving governance by enhancing discipline and consistency can increase performance by 1% to 2% per year. That should provide ample incentive for committees to consider the following strategies, and we believe these two updates to a plan’s governance will be considered best practice by 2025.
- Establish investment beliefs – Investment beliefs are a series of high-level principles, unique to each committee, that guide decision-making and supersede the personal views of individuals. Because codified investment beliefs are foundational for improved governance, we strongly believe they should become standard for all large DC plans. We also expect to see a more prominent focus on Environmental, Social and Governance (ESG) factors in investment beliefs and investment policy statements.
- Delegate investment decision making – Committees are often composed of senior level executives with competing priorities, who have limited capacity to spend added time focusing on the organization’s retirement plans. DC committees would benefit by deciding to focus more time on strategy and outsource investment decisions to either an internal sub-committee (e.g., staff) or to an outsourced chief investment officer (OCIO). By 2025, we believe that this will become the standard approach for DC plan oversight.
Funding future DC “liabilities”
Unlike pension plans, most defined contribution plans are primarily funded by participants, with only modest contributions coming from plan sponsors. Since investment performance is only a small part of what is necessary to achieve a successful retirement outcome, it is important that committees re-evaluate their funding policy. The objective should be to ensure that participants have sufficient assets to replace their income in retirement, which could be considered their future liability. By 2025, we believe that there will be broader utilization of multiple employer plans (MEPs), which will expand coverage and increase overall savings for our retirement system, and committees should have more tools and thus will spend more time on strategies designed to optimize total contributions.
- Expanded coverage through MEPs – With the passage of legislation supporting open MEPs, they are very likely to become a viable alternative for both small and large employers by 2025. In this scenario, the` number of workers covered by a plan will increase dramatically, which will improve the overall funded status of the U.S. retirement system
- Lifetime income disclosures – Legislation has passed that will require employee statements for private sector DC plans to include an estimate of projected monthly benefits. By providing this estimate, participants will then be able to use the tools provided by their plan’s recordkeeper to more closely approximate the total assets needed at retirement, and adjust their funding level to reach that goal.
- Turning behavioral headwinds into tailwinds – Optimizing the use of automatic features is one of the strategies plan sponsors may use to improve their overall funded status, but some approaches may require additional financial commitments at a time when budgets are already stretched. However, much like how organizations periodically review the funding policies for their pension plans, it is critical that employers understand the impact their decisions have on funding DC benefits. We believe that by 2025, there will be increased emphasis on aligning plans with organizational priorities, and sponsors will focus on strategies to ensure that participants are on track to reach their retirement goals.
- Utilizing retirement readiness studies – Similar to the approach of evaluating a pension plan’s funded ratio, plan sponsors should periodically conduct a retirement readiness study to better understand the equivalent collective “funded status” of the participants in their DC plan. It is particularly important to establish this baseline prior to implementing investment or plan design changes, including those designed to turn headwinds into tailwinds, to enable the employer to measure the impact of its decisions. We believe these will be considered best practices by 2025.
Designing menus and constructing portfolios to improve participant outcomes
Investment menus for many DC plans historically have included a long list of options that are tied to style and capitalization boxes. Employers who still view DC plans as supplemental often emphasize choice over the quality or clarity of investments. However, as fewer employees are covered by a pension benefit, it becomes even more important to have a clear and well-designed DC menu. DB plan fiduciaries have long understood that creating portfolios with the appropriate balance between return seeking and hedging strategies most often leads to success, particularly at the end of the glidepath. We believe that DC committees should consider incorporating similar strategies to improve the efficiency of their plan’s investment options.
- Alternative or diversifying strategies – Similar to the approach used by large, well-run pension plan portfolios, incorporating alternative strategies such as real estate, hedge funds and private equity can add this type of diversification. This may be accomplished today in a white-label structure for the core investment menu or in custom target date funds (TDFs). While it may take legislative relief or a prolonged bear market, more committees will be considering strategies long considered best practices for large portfolios.
- Personalized default options – Advances in retirement technology have paved the way for a new category of default solutions that are personalized to each participants’ unique characteristics and preferences. These solutions are legally and operationally managed accounts, but they’ve been specifically designed to function as the plan’s QDIA. Since recordkeepers now allow plans to use almost any manager in their investment menu, we are hopeful that they will also move to open architecture for managed account providers, paving the way for broader availability of these types of solutions. Assuming we see these positive changes, we believe that use of managed accounts as QDIAs will increase significantly by 2025, and annual cash flow could eventually surpass the level of assets directed at TDFs.
- Efficient implementation – By 2025, more DC plans will use implementation specialists because they represent a natural extension of the current focus on fees and costs. The pitfalls of relying on money managers to transition assets between mandates are becoming more apparent as DC plans move away from mutual funds to more institutional structures. Efficient investment implementation reduces turnover and trading costs, keeps participants fully invested in the capital markets and avoids blackout dates and performance holidays commonly associated with transitions in DC plans today.
- Replacing monthly pension payments with income from a DC plan – To supplement income from Social Security, committees should consider adding a retirement tier, including both guaranteed and non-guaranteed options, designed to provide predictable income. This will provide employees with the confidence to avoid delaying retirement, and will allow employers to better deal with workforce management issues. Along with the recent passage of the SECURE Act, we believe this provides enough incentive for plan sponsors to introduce decumulation options, which will result in growing use of these strategies by 2025.
Although DC plans today appear to be significantly different than the first generation, the pace of meaningful change now seems painfully slow. Whether committees are paralyzed by litigation concerns or are awaiting legislative clarity, the adoption rate of most strategies that will positively impact participant outcomes continues to be low. For DC plans to succeed as our primary retirement vehicle, it is important that committees consider the strategies discussed in this blog and prioritize those that will be most impactful to their participants.