Defined Contribution Investments on Trial

In Defense of an Institutional Approach

 

In the Defined Contribution (DC) space, there is significant debate as it relates to the appropriate investment approach to help participants build and manage retirement savings. 

While there are a spectrum of solutions and many plans do not fall squarely in any one category, three broad approaches under scrutiny are: 

  1. The Retail Approach
  2. The Simple Approach
  3. The Institutional Approach

Adopting an institutional mindset is imperative to driving successful outcome for participants, but how exactly is an Institutional Investment approach defined? 

Characteristics of an Institutional
Investment Approach

Application Within Defined Contribution Plans

Outcome-oriented investments

Extended credit sectors, private assets, absolute return, and real assets

Broad asset class diversification

Extended credit sectors, private assets, absolute return, and real assets

Best-of-breed investment management

Skilled investment managers that are institutional in nature

Thoughtful mix of active and passive

Hybrid target-date strategies and customized open-architecture funds

Vehicle agnostic

Institutional mutual funds, collective trusts, and separate accounts

 

Here, we will make the “case” for an institutional approach from an investment, fiduciary, wellness, and fairness perspectives.

1. The Investment Case: Enhancing risk-adjusted performance


Most institutional portfolios incorporate exposures to:

  • Both passive and active management.
  • Active management comes at a higher cost, but the benefits of alpha over long horizons can be significant.
    • Simple analysis shows that if a participant can achieve just 35 basis points (0.35%) of alpha annually over a lifetime, assets can last an additional 6 years in retirement.
  • Active equity managers have historically outperformed in down and volatile markets, potentially befitting participants who tend to react negatively in times of stress and are particularly susceptible to sequence of return risk around retirement age.
2. The Fiduciary Case: Putting the interests of participants first

 

  • Perceived litigation risk has been one of the biggest drivers of DC plan sponsors moving towards the simple investment approach.
  • This trend actually creates more legal risk by putting the sponsors' interests ahead of the participants interests, and ultimately retirement outcomes in jeopardy. (See chart below)
  • Meanwhile, the courts and other industry stakeholders continue to highlight that ERISA does not require selection of the cheapest investment options.
  • Fixed income is a great example of this:
    • Very few institutional investors invest passively in fixed income given structural issues with benchmarks, the ability of active managers to add value historically, and the need for more customized solutions

Source: Cerulli Associates: US Retirement Markets 2017; Large Plan Sponsors

 

3. The Wellness Case: Improving retirement readiness

 

  • 57% of employees are very or somewhat stressed about their financial situation, particularly saving for the future.
  • 401(k) participant savings rates, when combined with employer contributions, fall at the low end of the recommend range.
  • As a result, more emphasis is being put on delaying retirements, however this comes at a great, and often unknown, expense to employers. (See chart below)
  • One way to improve retirement readiness is taking a vehicle agnostic approach to investment menu design.
    • For example analysis shows that moving to commingled vehicles can result in significant fee savings

Cost of Delayed Retirements to Employers: Composition of Private Sector Workforce Costs

Notes:
  1. DB retirement plans include premiums, administration fees, and dollar amounts placed by employers into pension funds.
  2. Supplemental pay includes overtime, shift differentials, and nonproduction bonuses.
  3. Government payroll-related includes Social Security, Medicare, Federal and State Unemployment Insurance and Worker’s Comp.
Source: Bureau of Labor Statistics, Employer Costs for Employee Compensation – March 2016, Table 5, June 2016. Prudential Financial analysis with supporting research by Goldenson Center at University of Connecticut.

 

4. The Fairness Case: Bringing institutional solutions to individual participants

 

  • Plan sponsors should look to portfolios of their institutional peers when designing investment options, most notably around extended credit sectors, alternatives, and private assets.
  • As an example, private real estate has historically been a strategic allocation in institutional portfolios and also relied upon by individuals in building and growing their wealth.
  • In analyzing private real estate's impact on retirement outcomes, we find that a modest allocation in multi-asset portfolios results in a meaningful reduction in both the magnitude and ranged of projected portfolio drawdowns.
    • The benefits of this effect can be significant in reducing sequence of return risk around retirement and keeping plan sponsors committed to their investment selections.