Harmonizing DB and DC: Part one – It begins with governance

If you’re a plan sponsor that has outsourced, or has considered outsourcing your organization’s DB plan, why wouldn’t you do the same for your DC plan?

In this two-part series, we’ll discuss how harmonizing DB and DC investment approaches can deliver economies of scale and help simplify and aggregate responsibilities, while demonstrating fiduciaries' strong adherence to best-practice governance disciplines.

Let’s start with what you believe.

Aligning actions with investment beliefs

While an organization's DB and DC retirement plans typically share the same investment committee members, these plans don't always share a consistent investment approach. DC plans have embraced the simplistic and low-cost appeal of passive management, undoubtedly spurred on by the increased focus on fees following regulatory scrutiny and a related spike in class-action lawsuits. Yet the same plan sponsors that accept this basic DC plan approach often adopt a completely different institutional approach in their DB plans.

Fiduciaries should seek to align the management of both their DB and DC plans with their investment beliefs. Some committees opt to create a statement of investment beliefs to document their overarching beliefs, while others simply allow their actions to imply what the underlying belief set is. Where plan sponsors identify inconsistency between implied beliefs and their actual beliefs, we’d encourage a discussion around whether there are justifiable reasons for such inconsistency to continue.

As we look across the industry, some of the most apparent contradictions of investment beliefs relate to inconsistent decisions being made across DB and DC plans, most often in such areas as the types of investments, choice of investment vehicles and governance processes. Plan sponsors who are taking inconsistent approaches to managing their DB versus DC plans should have defensible reasons for doing so. Otherwise, they should consider harmonizing their approaches.

Harmonization doesn't require that DB and DC plans be managed in exactly the same way, but plan sponsors should at least look to apply a consistent set of investment beliefs and, where practical, to directionally align their investment approaches across both DB and DC plans.

Why harmony matters

Plenty of evidence shows that outcomes for DC participants have trailed those of DB plans, mainly due to high fees, lack of portfolio diversification and poor market timing by participants. A more harmonized approach may lead to improvement in DC plan outcomes. A harmonized approach also signals to employees that the organization is applying a consistent framework for selecting the types of investments and services that are most likely to meet the objectives of both the company and its employees.

Applying different investment policies and standards to the two types of plans can also suggest inattentive or inconsistent governance practices, which opens fiduciaries to questions about their oversight and policies.

Finally, many DB plans have refocused the management of the plans’ pension assets away from an asset-only approach and to an approach that considers both the assets and the specific liabilities of the pension plan, as well as the financial situation of the plan sponsor. A harmonized approach would move beyond the benchmark-centric measurement of most DC plans, in which success is based on the funds in the plan outperforming a benchmark and apply the same liability-driven philosophy to DC plan participants.

Dissonance in governance

 

Governance is the first area where we have observed differences in approach between DB and DC plans. How a plan sponsor oversees the plan, makes investment decisions, defines the investment policy and works with vendors are all part of the governance process.

Exhibit 1 highlights a few questions designed to start a dialogue among fiduciaries for evaluating the consistency of their governance approaches across DB and DC plans.

Balancing governance practices chart

 

We observe that many plan sponsors will spend significant time and internal and external resources on managing their DB plans, yet will not bring those same resources to bear on their DC plans, nor dedicate an adequate amount of committee meeting time to DC.

A critical aspect of governance is determining which fiduciary responsibilities the Committee will retain and which it will delegate to staff or to a third-party outsourcing provider. The role of outsourcing has grown rapidly among DB plans, but the DC plan is sometimes carved out of the outsourcing arrangement and managed internally or under a traditional 3(21) consulting model. This model can lead to missed opportunities for DC plans. In fact, many of the same benefits to outsourcing a DB plan are applicable to a DC plan:

  • Reduce fiduciary burden on the plan sponsor by contractually delegating fiduciary duties.
  • Simplify and aggregate plan management responsibilities.
  • Potential to lower cost and increase operational efficiencies.
  • Manage legal and compliance risk.
  • Spend more time on strategic decisions. Spend less time on operations and monitoring vendors.
  • Increase decision speed.
  • Enhance the investment program and keep pace with continually evolving markets.

Layered over the benefits of outsourcing are the structural headwinds facing DC plans. DC plans are entering a prolonged period of net outflows in 2020 with the mass retirement of the baby-boomer generation, making the potential cost savings delivered by the OCIO model even more attractive. Also, the transition from DB to DC as the primary retirement benefit has left workers with retirement risks that didn’t exist in the DB system, namely contribution, longevity risk and behavioral risk. Outsource providers are uniquely positioned to enhance DC retirement programs to better meet the needs of the vast majority of American workers who are underfunded for their impending retirement.

Another benefit to outsourcing is that it preserves the historical performance track record when investment managers are swapped out. Under the traditional consulting model, it’s standard practice for the new manager’s track record to replace the previous manager’s track record for reporting purposes, essentially papering over the historical performance that participants actually experienced. With outsourcing,  the committee is presented with the actual performance results experienced by participants. Every manager change is captured in the performance track record of the funds, along with every basis point of transaction and implementation cost (in the traditional consulting model, the transaction costs incurred swapping out the managers may not be part of the track record).

While DB and DC plans may have separate and distinct objectives, as well as structural differences and requirements, hiring a single OCIO partner that can align investment and management approaches across DB and DC plans can bring consistency, provide economies of scale and help simplify and aggregate responsibilities.

The Investment Policy Statement

 

The Investment Policy Statement (IPS) is an important component of the governance process because it outlines the objectives and policies for the plan and generally outlines the investment option structure and underlying philosophy. Plan fiduciaries are responsible for ensuring that the plans are managed in accordance with their IPS, and therefore we recommend that the IPS provides meaningful guidance to the plan fiduciaries, without imposing an obligation to act in any particular way. That said, plan fiduciaries should review the IPS for the DB and DC plans to determine whether the differences are justifiable. Some common areas of inconsistency are:

  • Real assets – Allowed in DB plan but not DC plan
  • Non-U.S. equity benchmark – Contains emerging markets in DB plan but not in DC plan
  • Fixed Income – Out-of-benchmark exposures permitted in DB plan but not in DC plan
  • Performance objectives – Longer time horizons for DB plan
  • Delegation of investment management functions – Allowed in DB plan but not in DC plan

We encourage DC plans to also adopt the DB mindset when establishing plan objectives. A common objective for a DB plan is to provide funds for the satisfaction of participant benefit payments, which is outcome focused. On the other hand, a common objective for a DC plan is to provide an appropriate range of asset classes and investment options that will reasonably span the risk/return spectrum, which is not outcome focused. To harmonize DB and DC plan objectives, establish income replacement as the DC plan’s primary objective and consider including language in the DC plan’s IPS that states the ultimate goal of the DC plan is to provide a means for participants to fund a retirement income stream. Develop a Target Income Replacement (TRI) goal for the plan and measure participant progress toward the TRI with periodic replacement income studies. Determine participant replacement income studies conducted by your DC plan recordkeeper, consultant or fiduciary provider.

The bottom line

As you think about your organization's DB and DC plans, we encourage you to commit to consistency in your governance approach and investment philosophy across plans, and to ensure that any inconsistencies are justifiable, particularly from the perspective of achieving ultimate goals. This applies to outsourcing decisions as well. If you explore the OCIO model, consider a single trusted OCIO partner for both types of plans. With the DC plan representing the future of retirement at most organizations, commit to giving the DC plan the attention and resources it deserves (e.g., internal or external), just as we have been doing in DB plans for decades.

And stay tuned for part two of this series, where we talk about harmonizing the types of investments in DB and DC.

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