With the industry focused on retirement readiness and more defined contribution plan members on glide paths, it’s increasingly important for plan sponsors to choose default investment funds suited to the present and future.
Fortunately, these funds have been shifting away from their conservative roots. Money market funds, for instance, were once a common default in Canada’s DC plans. They’re a conservative option because they invest in short-term debt securities that are broadly considered low risk. Even though these funds’ returns are inadequate for boosting savings, some plan sponsors are still using them as their DC plan’s default option, says Katherine Rapp, senior vice-president of DC retirement services at NFP Corp.
Read: OSFI publishes guidance on default investment options in DC pension plans
“We see members that are stuck in money markets forever and their plan sponsors have never changed the default. It’s very sad when a member wakes up and realizes too late in the game that they should have been investing in something even slightly more aggressive, without taking on too much risk.”
Investment funds with such low return potential, like money markets, are inappropriate, says Rapp, especially considering that a member could actually see a negative net return with the wrong combination of circumstances.
“Typically, especially if you look at the last 10 years, [with] a standard money market fund you probably wouldn’t even earn a full per cent a year,” she says. “And when you take a fee . . . . You can pay a higher fee than the return you’re getting, depending on the pricing model.”
Slightly better, but still stagnating, are DC plans offering guaranteed investment certificates and daily interest funds as their default, says Rapp. “We still have clients that are stuck back in the . . . Dark Ages, where they’re fearful of moving from a GIC,” she says.
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“We meet with them annually. We give them all the information and all the reasons why it would be ideal from a risk and reward perspective. And with all of that, we still have a small percentage of clients in our books that refuse to move.”
Many plan sponsors are still loyal to balanced funds, according to Jennifer Gregory, senior vice-president for group retirement solutions at People Corp. Often, DC plan sponsors will also have a defined benefit plan on their books, so the 60/40 stock versus bonds split of a typical balanced fund feels familiar and they’re happy to essentially duplicate it in their DC plan, she says.
As well, while plan sponsors that stick with their historic default may see the potential advantages of a more sophisticated option, such as a target-date fund, they may not want to disrupt their members, says Gregory.
Shifting landscape
While target-date funds are the most popular default option for U.S. DC plans, money market and balanced funds are gradually decreasing as a percentage of the total.
| 2015 | 2017 | |
| Target-date fund | 85.5% | 85.2% |
| Money market or stable value | 7.7% | 0.9% |
| Balanced fund | 3.4% | 2.6% |
Source: Callan survey, 2018
Ramping up risk
For the most part, plan sponsors are moving away from conservative default options, but controlling risk is still a fundamental principle when choosing an appropriate fund, says Ruo Tan, president of Segal Rogerscasey Canada. These days, he notes, that means controlling a default fund’s equity component.
In 2017, 50 per cent of DC plan sponsors allocated target-date funds as their default option, according to a survey by the Canadian Institutional Investment Network and Great-West Life Assurance Co. These funds are prevalent because they can control the equity component in a reasonable way over time, without any action required by the plan member, says Tan.
Read: More pension plans using target-date funds as default option
“Most companies today have adopted target-date funds. They have to be the most important default option in the DC platform,” he says.
In order to achieve any real growth, the fund has to include actual risk, he adds. “From a company point of view, you get away from the liability down the road of someone saying, ‘How come my investment is not performing? Where’s my return to support my retirement?’”
However, not all target-date funds are created equal, says Tan, noting research shows Canadians live longer than Americans, so a solution developed for one market won’t automatically translate to another. And while a specific default fund may be a great choice when a member initially joins a plan, people’s circumstances can always change, he adds.
Guiding light
In 2018, the Office of the Superintendent of Financial Institutions published plan sponsor guidelines for choosing default funds.
They include:
- Balance is in, risk aversion is out: The default should have a mix of fixed income and equities, allowing for both capital appreciation and preservation;
- Cost conscious: Plan sponsors should be wary of how fees can affect a members’ accumulated funds and make their investments less efficient;
- Prudent policy: While DC plan sponsors don’t have to set out a specific investment procedure, they should implement policies to ensure they’re meeting their fiduciary duty;
- Keep it clear: Communications should relay how the fund invests, its goals, past performance, top-10 holdings, risk, fees, a relevant benchmark, target allocation and a disclaimer that past performance doesn’t indicate future results; and
- Review and refresh: Plan sponsors should continue to review the default fund, especially on events like consistent over- or underperformance, cost or manager changes and serious market or economic shifts.
Spreading specificity
It’s also becoming more common for default funds to feature a wider array of assets within a given vehicle, says Janice Holman, principal at Eckler Ltd.
“There’s a big move to looking at how to make target-date funds more similar to DB pension investments, so looking at bringing in illiquid investments or alternative investments that will enhance diversification of the portfolio, which can be a little bit trickier because these funds are daily traded,” she says. “Some time and thought has to be put into how having illiquid investments in the portfolio will be managed with cash flows and the need for daily liquidity of the fund.”
Read: Are target-date funds the best investment option for CAP decumulation?
When target-date funds first came to market, they were fairly simplistic, says Holman. “There wasn’t necessarily a lot of research that went into creating the glide path; they were more what we call ‘market-consensus.’”
These days, research seeking to improve target-date funds is focused on how they can work better for specific demographics, she says. As they become more specialized, it’s all the more important for employers to understand the underlying assets and mechanics of the fund to be sure they’re choosing the optimal option for their plan member population.
“More of the providers . . . are doing a lot more demographic and statistical analysis of populations to see what people are actually saving,” says Holman. The research is increasingly focused on the economic environment, its changes over time and people’s actual retirement experiences, she adds.
“Instead of just being an asset-only composition of the target-date fund, it’s being made specific for certain populations.”
The right choice
One of the reasons it’s so important for a DC plan to choose the right default fund is members aren’t financial experts and, oftentimes, they’re relying on their plan sponsor to make the choice for them. Indeed, Benefits Canada’s 2016 CAP Member Survey found just 17 per cent of respondents fell into the category of confident, meaning they felt ready for retirement and have the knowledge to make financial decisions for themselves.
And, although 63 per cent of respondents said they consider themselves a knowledgeable investor and 88 per cent said they’re realistic about their current and future financial position, 48 per cent agreed they don’t have enough time to spend on investing and financial matters, and 50 per cent said they find such issues too complicated.
Read: 2016 CAP Member Survey: Deconstructing how different employees view their retirement
While it’s difficult to ask the average employee to choose their own investments, it’s also potentially unrealistic, says Susan Bird, president of the McAteer Group of Companies. “It’s unfortunate. I think that people are asked to make a decision on something they have no expertise in. They’re doing jobs we can’t do — they’re building nuclear reactors, they’re driving trucks, they’re looking after children. And I’ve always felt it’s unusual that we also expect those people to now learn about investments.”
Agreeing with that philosophy, Saskatoon-based Cameco Corp. changed its default option from a balanced to a target-date fund in 2017, while continuing to offer target-risk funds as well. “In speaking with employees, we do find that investing is not their job and, certainly, there are a lot of people who have concerns with making those investment decisions,” says Vicky Rowan, the organization’s manager of total rewards.
Cameco’s DC plan is mandatory for all employees, with a six per cent employer matching contribution. “We don’t have that concern with engagement or trying to promote to employees to save more,” says Rowan. “We have very solid contribution rates from both the employee and the employer. With adding the target-date funds and maintaining the target-risk funds, we feel we are providing appropriate diversification and investment options for our employees.”
The nudge effect
However, not everyone agrees that plan members should take a backseat, even with a healthy default fund in play. There can be unintended consequences of relying too heavily on a single default option and expecting that the majority of members simply won’t engage, says Sasha Tregebov, principal advisor at the Behavioural Insights Team.
“When we go with the default option, we’re not required to engage, so if we have these really smart defaults, as we expect, people take up those defaults at a high rate,” he says.
Read: 2017 CAP Member Survey: Plan sponsors urged ‘to be courageous’
But if plan members aren’t initially engaged, it opens the door for less engagement in their overall financial security and retirement preparedness, says Tregebov. So in an environment where default options allow members to set it and forget it, plan sponsors must find other ways to engage employees on financial issues, he adds, noting it’s critically important to make it as easy as possible for plan members.
“We see these really clear frictions — caused by extra steps, complexity that we make people work through — have outsized impacts on their behaviour and choices. So one does need to be careful,” says Tregebov. A questionnaire that members can easily answer, he suggests, can get the wheels turning on prioritizing retirement goals.
Fall into the gap
Whether a DC plan is mandatory or voluntary is another side of the default fund debate. In plans where participants are automatically enrolled with the option to leave, enrolment rates are much higher than plans that require members to take action to join, says Tregebov.
Read: Custom target-date funds growing in U.S.: survey
In the U.K., the data was so convincing, it led to auto-enrolment legislation, which was phased in gradually from 2012, requiring DC plans to automatically enrol all members.
“The government has introduced and now implemented legislation that does require employers to have an opt-out system, rather than opt-in,” says Tregebov. “So we’ve seen this movement from the academic work around defaults and retirement, to shifts in industry, to now governments and policy.”
Martha Porado is an associate editor at Benefits Canada.