A report released on Tuesday by Schroders studied defined contribution plan design in several countries to try to determine the most effective design. While the report states that participants should be able to make their own decisions about their plans, it acknowledges that left to their own devices, few investors are able to actually make decisions that lead to good outcomes.
“Few are interested or engaged in pension planning and many do not have the financial education or personal data to help in these decisions. Given this reality, members must be helped,” according to the report.
Consequently, one of the main solutions for improving outcomes in defined contribution plans is simply forcing participants to save.
As we’ve seen in the United States, automatic enrollment programs are generally successful in overcoming workers’ inertia. The report found that several countries have taken automatic enrollment to its furthest extreme and made contributions to a state or corporate defined contribution plan compulsory, disallowing opt-outs and setting mandatory limits for contribution. Singapore, Hong Kong, Australia, New Zealand and Sweden are all examples of countries that take this route.
However, Schroders found that even where participants are compelled to make contributions, the rates may still be too low given expectations for long-term future returns. Schroders referred to a report by CPA Australia that found that country’s compulsory rate, which will increase to 12% by July 2019, “may not be high enough for Australians to retire at the current retirement age.”
Replacement ratios, returns and other retirement provisions all affect the appropriate level of contributions. Based on an analysis for retirement plan participants in the United Kingdom, Schroders suggested that the combination of returns and contributions could be no less than 3.5% real annual return and 15% per year to get a participant to two-thirds of their final salary at retirement.
While compulsory contributions might improve account balances, they’re not without their own complications. For example, Schroders noted that in Australia, one concern was that mandatory limits may do more harm than good in low-income households.
Automatic escalation is one way to address lower-income workers’ difficulty making contributions. Setting contribution limits lower when workers are making less money, then raising the limits over time as those workers’ salaries increase keeps them in the plan without putting undue burden on their income. Schroders found that in the United States, 71% of 401(k) plans use automatic enrollment with automatic escalation.
“The impact of auto-escalation can be thought of as using members’ in-built inertia in their own favor, almost by stealth,” according to the report. “Since experience has shown that very few members ever alter their contribution arrangements, incorporating auto-escalation essentially turns the situation into one of ‘opt-out’ rather than ’opt-in.’”
Governments that want citizens to save more for their own retirement have to counter those citizens’ preference for current spending over future spending. “While such compulsion may seem draconian, it is the single most effective step that governments, regulators and/or sponsors can take to overcome the inertia,” according to the report.
Default funds and auto-enrollment go hand in hand, but the funds new participants are directed to need to be well-designed. “Clearly, identifying a single fund that is suitable for every new joiner is impossible due to the varying ages, periods to retirement, earnings, existing assets/financial position and other personal circumstances of each individual,” according to the report.
The United States, Canada and the United Kingdom favor target-date funds, Schroders found, and some U.S. and U.K. fiduciaries have begun designing target-date approaches that are more targeted to their employees.
One point of contention is whether a fund carries a participant through retirement or simply to it. Schroders notes the date in a target-date fund doesn’t indicate when the fund will start winding down its risk allocation to more conservative assets. In 2012, Standard & Poor’s launched indexes to track “to” and “through” funds based on the equities in each fund and how quickly they de-risk.
Boomers who were only a few years away from retirement in 2008 when the financial crisis was siphoning assets out of their portfolios can attest to the importance of limiting losses near retirement. Schroders found that losses suffered 30 years into a participants’ plan are around 15% higher than a loss after only 10 years of saving.
Similarly, big gains have a bigger effect on a bigger account balance. Schroders found that a 20% gain for a 20-year-old will increase the account balance by 5% by the time they are 60; at age 50, a 20% gain would increase the balance by 10%.
One way to avoid big losses while compounding real returns, according to Schroders, is to manage tail risk, either through derivatives or active management.
The majority of plans will be too small for managers to design funds for each participant, Schroders wrote. Sponsors could work with similarly sized plans to get the same result, or tailor funds for larger cohorts of similar participants.
One important factor, though, is that members who are defaulted into a fund rarely overcome the inertia that put them there in the first place and change. Consequently, default funds should be designed to take a participant all the way through their career.
Retirement plans frequently stick to domestic investments for several reasons. They’re more familiar to the participants, first of all, but they’re also frequently not allowed to invest large proportions of the plan in foreign assets, according to Schroders.
However, Schroders noted several arguments for investing in other markets:
- Access to economies that grow at different rates than the domestic economy
- Access to sectors that may be underrepresented domestically
- For small domestic markets, access to deeper and broader stock markets
- Overseas currencies can also provide a source of additional diversification
Mixing domestic and international investments can help dampen volatility, according to the report, although it acknowledged that it was an imperfect solution: “There will inevitably be short- and medium-term periods during which diversification delivers poor results. This occurred in 2011 when target-date funds in the United States had their worst period of absolute and relative returns since 2008 as a result of diversifying into small-cap, non-U.S. and emerging-market equities. However, in most years, international diversification paid off in these funds through smoother returns, higher returns or even both.”
Retirement isn’t a single event that can be planned for like a vacation; it’s a new phase of a person’s life, one that could last 20 years. How are plan participants going to live during those years?
The report noted that some plans buy annuities to provide retirement income, some draw from a retirement account and some provide partial guarantees. In a low-yield environment, annuities and guarantees are expensive, though.
“Improved life expectancy, a low growth environment, extremely low bond yields in some markets and rising expectations about retirement lifestyles all contribute to making this a difficult problem to solve,” the report says.
Schroders noted, too, that even though participants want guaranteed income in retirement, they’re not always willing to pay extra for it.
Flexibility, then, is the answer, even though it’s not a very conclusive answer. One solution would be to “average in” to annuity purchases, buying deferred products before retirement begins and throughout the first few years to avoid the high cost right as retirement begins.
Of course, TDF glide paths can always be extended to carry participants farther into retirement, the report suggested.