In my last blog post, I argued that the main problem with the defined contribution (DC) model today is the inherent need for plan members to make proper investment decisions despite difficulties equipping them with the expertise required to do so. As a follow-up, I will outline investment choices typically available to DC plan members, highlighting both the benefits and the deficiencies of each option, and how they can alleviate the problem. Finally I will put forth what I believe to be the soundest approach for the DC model going forward.
Target Risk/Lifestyle Balanced Funds
Evolving from traditional 60/40 balanced funds in the U.S. in the late 80s through Fidelity Investments, target risk funds are a group of investment products with descriptive names like “conservative” or “aggressive” that aim to span the full spectrum of risk tolerances. The reliance and onus is on each member to rationally identify their own willingness and ability to bear risk, and select an appropriately-aligned fund with the same risk exposure.
The primary advantages of a target risk fund are diversification benefits with just one fund choice, and a steady risk exposure over the life of the investment. The explicit risk exposure means a member need not worry that the style and risk exposure of their investment will ‘drift’ over time.
There are several drawbacks to this model. First, I would challenge the premise that most members are able to dispassionately assess both their willingness and ability to take risk. There are undoubtedly many instances of individuals aggressively seeking high returns, only to lose their resolve when things go awry in the short term. Another problem is that though a plan member’s willingness to take on risk may never change, their ability to do so will almost certainly change over the course of their working lives. Life events (e.g. changes to personal/household income, the arrival of new family members, inheritances, etc.) must be considered in order to assess risk tolerance on an ongoing basis. Unless a plan member is actively being encouraged to view their risk tolerance at a holistic level, the result could be asset allocation (and performance) that is less than ideal for their retirement savings.
Target Date/Lifecycle Funds
Originally introduced in the U.S. by Wells Fargo and Barclays Global Investors in the early 90s, target date funds are investment products designed with the goal of gradually shifting the asset mix out of equities and into fixed income as the fund’s vintage or maturation date approaches.
The benefits of a target date fund in a plan member’s portfolio again include diversification, as well as a lifelong built-in investment strategy and disciplined or automatic asset mix rebalancing. An additional benefit of target date funds is that management fees should decline as the asset mix shifts into more conservative fixed income instruments over time.
The drawbacks of this approach are a bit more nuanced – while offering diversification between equity and fixed income, the asset mix for funds with similar target dates are far from uniform, varying widely among different providers. This makes meaningful comparison between the providers – or even analysis of historical results – difficult if not impossible. In addition, most DC plan members will be offered only one suitable target date fund provided by their retirement fund administrator. Target date funds offered by a provider are typically comprised of other funds offered by that same provider, which could compromise the fund selection process and result in a collection of suboptimal funds that are not best-in-class.
The greatest deficiency with target date funds, however, is that their sole focus on age (or years to retirement) fails to recognize other factors, including loss aversion (i.e. willingness to take risk) and overall financial position and other commitments (i.e. ability to take risk). Two plan members born in the same year does not alone imply that they should have identical risk exposures in their retirement savings, unless all else is equal.
Managed/Discretionary Accounts
Developing out of separately managed account (SMA) investment products by E.F. Hutton in the 70s, managed accounts are a final investment approach that could be considered a suitable DC option. The idea behind these accounts is to consider various factors such as age, savings, and risk tolerance, and use them to determine an appropriate portfolio strategy for the investor. The investor then delegates responsibility for decisions so that they do not need to make investment decisions themselves.
The fundamental benefit of a managed account is the ability of the manager to customize the portfolio to the specific needs of the individual. By reflecting the individual’s assets, debts, risk tolerance, and cash flow requirements in aggregate, the portfolio manager can build a portfolio best suited to the investor’s profile.
The main drawback of a discretionary managed portfolio is that fees can be high due to the extra tailoring required for each client. Comparison between managed account providers can also be tricky given the wide variations among them. Such personalized service makes more financial sense where large account balances are involved, so there is often a minimum asset level requirement; hence, this strategy is not accessible to (or feasible for) a great many individuals.
In my previous blog post, I noted that most Canadians in the private sector do not have the luxury of participating in a defined benefit (DB) plan – but that does not mean we cannot learn from the lessons that DB plans impart. DB plans in Canada were first introduced in the early 20th century to look after elderly widows and military veterans – and structured with the idea that investment decisions in their members’ best interests were made on their behalf.
The April 2011 Benefits and Pensions Monitor article entitled Dynamic DC: A Real-world Solution by Kevin Sorhaitz, a principal and consulting actuary for Buck Consultants, succinctly summarizes my feelings on this: “a traditional DB plan consists of the accumulated knowledge and experience of consultants, investment experts, and actuaries hired to actively monitor and assess the level of contributions required and the optimal investment mix… the only duty of the [DB] plan member is to remit contributions… are we really asking the average investor in a DC plan to replace the training, knowledge, and experience of investment and actuarial experts?”
While DC plans are the way of the future, we can still employ the DB notion that for many if not most members, it may be best to have investment decisions made on their behalf. The three options listed above are the main solutions to help bridge that gap between a member’s need to make decisions in a DC plan, and the fact that most members are ill-equipped to make those decisions properly.
So what is the best solution? In my opinion, given the strengths and flaws outlined above for each product, it would be a hybrid solution that merges the benefits as much as possible while minimizing the limitations. A product that combines the lower cost and risk tolerance consideration of the target risk fund, the simplicity and asset allocation strategy of target date funds, and the customization and notion of professional management with discretionary accounts would be the ideal solution to solve the problem with the DC model today.