As of 2013, Canada had more than one million defined contribution plan members, reports Statistics Canada. That’s quite a number of future pensioners — all hoping for adequate retirement income.
If plan sponsors don’t want litigious employees suing over a shortfall in retirement income, they need to start thinking about DC plans that can deliver. An effective DC plan should consider three areas: investments, design and decumulation.
1. Simplify investment choices
Plan sponsors need to think not only about investments but also about retirement objectives — similar to the way defined benefit plans look at assets and liabilities, explains Zaheed Jiwani, senior vice-president, client strategy, with Greystone Managed Investments. “If employees are only putting in 2% of pay, you’re going to need more from the investments,” says Jiwani. “If they’re putting in 10%, you need a little bit less from the investments.”
Read: Q&A: The DC plan landscape
DC plan sponsors are looking at employer contributions more seriously. A 2014 Vanguard study of more than 90 multinational companies with both DB and DC plan assets found 71% of plan sponsors expect to increase employer contributions to their DC plans.
But if DC plan sponsors aren’t already integrating investments and retirement needs, it might require a catastrophic event to get them thinking this way, says Jiwani — just as the 2008 financial crisis caused many DB plans to look at their assets together with their liabilities. “I think the only big catalyst is another financial crisis or a lawsuit with a group of retirees.”
As for the actual investment funds, à la carte options should include a mix of domestic and global assets across fixed income and equities, says Matthew Williams, head of defined contribution with Franklin Templeton. Plan members shouldn’t have direct access to more esoteric options such as stand-alone hedge funds, he adds, given their level of complexity for financially illiterate plan members.
Read: How to improve DC communications
“Certainly, [with] the workforce we’re dealing with now, there’s a limit to how much you can influence with education,” says Nigel Branker, a partner with Morneau Shepell. “That may be generational, as we start to see more financial literacy initiations in high schools and universities.”
But plans do need some funds that are “further out on the risk curve without too much risk of real long-term damage,” says Ian Baker, senior vice-president, head of fundamental and quantitative research, with Pyramis Global Advisors. He points to asset classes such as real estate investment trusts and incomeoriented equities.
Inactive or disinterested plan members, of course, will simply fall into the default option. Many investment managers agree a target-date fund, which reduces the allocation to less risky investments as the member moves closer to his or her retirement date, is the best option. In fact, the Vanguard study found 66% of plan sponsors prefer to use a TDF as the default option.
“A TDF should include a mix of fixed income and equities: domestic and global, Canadian, U.S. and international, with both active and passive options, to focus on creating the best performance outcomes net of fees while managing risk,” says Williams.
For years, Veritiv offered a shortterm bond fund as its default option. “Over a period, it did quite well for people,” says Larry Ketchabaw, manager, international benefits, with Veritiv. “The downside, I would say, is there is still some risk with it.”
Read: Avoiding DC class actions
Bothered by this, Veritiv is now moving to a TDF, scheduled to be introduced at the end of this year. “It’s more in line with where the world is now,” he says. Once a plan sponsor decides on the investments, how many options will it offer? 10? 40? What about 100?
Behavioural economics suggests that, with too many options to choose from, people will actually make no choice. But there is no maximum number of investment options recommended in the CAP guidelines.
Williams says this has to change. “What actually has to happen, in my opinion, is that the CAP guidelines need to be tightened so as to limit the number of investment choices the plan sponsor can make available.” He suggests offering TDFs plus a small suite of additional investment solutions.
2. Use auto features
Another design aspect is the use of auto features (i.e., auto-enrolment and auto-escalation of contributions). Branker says auto-escalation is “a clever tool” that’s had good success south of the border. “It’s a way of having members contribute more. I think it’s effective, but it’s a little bit blunt.”
In an auto-escalation environment, all DC members have their plan contributions increased—whether or not they’re on track for retirement. “[You have to recognize] that every member is different. In some cases, the risk of oversaving is as bad as the risk of undersaving,” he explains.
Read: How well does auto-enrollment work?
Branker offers the example of an employee earning $50,000 who will also have government income sources in retirement. “Why would I auto-escalate their contribution to the point that they’re getting more in retirement than when they were working?” he asks. “I’ve asked that person to give up too much consumption today for consumption in retirement.”
Williams cites one Canadian plan sponsor that used auto-escalation in conjunction with increasing pay, introduced just last year for the first time. This sponsor gave a 3% pay increase, where 1.5% was directed as monthly contributions to each employee’s pension plan. The increase may not occur each year, Williams adds.
Employees haven’t really resisted it because it’s automatic, he says. “While it lessens the impact of the net pay of the individual, it improves the long-term likelihood of better retirement outcomes.”
Jean-Daniel Côté, a partner at Mercer, points to a DC plan that increases contributions and matching based on employee service. For example, if the employee starts off at a 3% employee contribution and a 3% employer match, after, say, five years of service, it increases to 4% and 4%.
3. Don’t forget about decumulation
While much of the focus of DC plans today is on accumulating retirement assets, plan sponsors can’t forget about the payout phase. Since the DC industry in Canada is still relatively young, there aren’t a lot of options, which can be frustrating for plan members.
Read: What DC plan sponsors need to know about the ORPP
One option is for employees to take their savings from the group program and transfer them to a bank or brokerage, for example, and into retail investment products such as mutual funds. “The big challenge I find for people getting to retirement is they go from an institutional or group plan, and when they retire, they get sent into the retail market,” says Côté. The newly retired employee experiences a jump in fees from, say, 0.5% to 1% in the employer plan to around 2% in the retail market, he explains.
A second option is the group life income fund or group registered retirement income fund. Some plan sponsors offer these funds to keep retiring employees under their program and continue offering the retirees more competitive fees. However, the sponsor has to be willing to retain fiduciary responsibility for the retirees, which it may not want to do.
A third option is offering LIF-like benefits with a pension plan. “So you pay yourself a pension, just like you would in a life income fund,” says Côté. However, while some are exploring this option— mostly public organizations such as universities—the uptake so far hasn’t been very high. (Not all jurisdictions allow it.)
This isn’t too different from the plan sponsor offering a LIF. In this option, however, the savings remain in the pension plan, explains Côté, allowing for some plans that don’t use a third-party provider for administration (e.g., an insurance company) to offer an alternative to plan members having to transfer to a financial institution. In this option, he continues, the plan manages the LIF-like payments instead of the individual.
Read: DC plan sponsors should be exempt from ORPP: money managers
Ketchabaw isn’t sure about decumulation, noting it may not be lack of desire but concern about responsibility that inhibits DC plan sponsors. “As plan sponsors, most of us are going to stay away from getting involved in the actual decumulation. Some of the universities are getting into doing that, and it’s wonderful. But regular industry — unless we’re forced into it, I don’t see that happening.”
He points to Vertiv’s frozen DB plan. “It’s still in deficit, but I suspect when we get a fully funded plan, we’ll look at an insurance company for an annuity,” he says, adding a plan sponsor will get rid of the ongoing expense, responsibility and administration that comes with a DB plan. “If you get into the decumulation aspect of the [DC] plan, you’re kind of creating that again,” he says.
DC plans have a long way to go in terms of smart design. But it’s better to invest upfront in delivering more efficient plans than to deal with legal fees for unhappy members.
Brooke Smith is managing editor of Benefits Canada.
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