Now that the panic is over, risk is no longer the main issue for DC plan sponsors. But whose responsibility is it, anyways?
While volatility in financial markets continues to pose a challenge to DC plan sponsors and members, the initial panic that followed in the wake of 2008 has somewhat subsided. De-risking DC—while still on the plan sponsor’s radar—is no longer the order of the day.
“I don’t think [whether or not to de-risk] is a chronic question that we are getting from clients all the time,” says Oma Sharma, partner and DC consulting leader with Mercer. She thinks clients were rightly concerned in terms of the 2008/09 markets about the potential impact of severely negative market conditions on the account balances of DC plan members and whether or not this would impact members’ ability to retire. “But in Canada, the DC plan market is still relatively immature: those in such plans have been in them for a relatively short time or maybe only going forward. I think that since the markets have recovered, the noise around volatility has died down and been replaced by a broader discussion of the strategies that can be employed in plans to improve retirement readiness.”
Read: Top DC plans see asset increase, but issues remain
This reaction may be reflective of a change in mindset among DC plan sponsors. “Given the environment, a lot of plan sponsors are less paternalistic than they used to be,” says Robin Pond, senior investment consultant with Buck Consultants. “So I’m not sure that all plan sponsors feel it’s their duty to mitigate the risks.” And Becky West, associate partner and DC practice leader with Aon Hewitt, is doubtful that plan members will drive de-risking activity. “I’m not so sure that plan members are aware of volatility, because they’re not all that engaged in the plan.” Among plans that make advice services available to their members, less than 10% of plan members bother to take advantage of those services.
Adds Sharma: “I think Canadian plan sponsors in general haven’t really stepped out of the box and done anything differently so far. That could be, in part, because product providers haven’t yet stepped up and offered new products to reduce risk.”
Target-date Update
One notable exception is target-date funds (TDFs), which have been available in Canada since 2005. Following an initially slow uptake, they have grown dramatically in Canada since 2010 to reach more than $10 billion in DC plan exposure (out of total institutional DC plan assets of about $110 billion). In the U.S. last year, more than US$55 billion flowed into TDFs, according to Morningstar. The proportion of U.S. DC plans offering such funds climbed to 84% in 2012 from 13% in 2004, and some 51% of DC retirement plan contributors used TDFs in 2012, according to a 2013 report by Vanguard.
However, Sharma doesn’t categorize TDFs as a de-risking strategy, since investors are not necessarily reducing their portfolio risk by investing in them. “It’s about taking more risk as you’re further from retirement and less risk as you come closer to retirement. They do reduce risk for plan members as they get closer to 85% equity allocation at the long end—so for members retiring far into the future, they’re actually quite risky. The returns can be very volatile in the longer-dated portfolios.”
One shortcoming of TDFs is that they don’t usually consider differences in risk tolerance among individuals, she adds. “Most products assume that if you and I both wish to retire in 25 years from now, we both have the same risk tolerance. But I may have a very different risk tolerance from you if I am independently wealthy or, conversely, debt-ridden,” says Sharma. “Rather than ask members a question about how much risk they want to take, you’re asking them a question about when they want to retire. That’s a much easier question for them to answer—but it does not consider risk tolerance at all.”
Another issue with TDFs is that they are difficult to benchmark. Is it feasible for plan sponsors to compare, say, a 2045 fund from one investment manager to another if the managers have very different assumptions and very different investment allocations for their portfolios?
West, however, downplays such concerns as challenges rather than disadvantages. “What we encourage our clients to consider, in looking at targetdate funds as a solution, is to ensure that there’s broad diversification. We know— and it’s been demonstrated—that this will help dampen some of the volatility that we’ve been experiencing over the last seven years.”
This diversification requires a greater mix within asset classes, she continues. On the fixed income side, it can mean not adhering to the DEX Universe Bond Index. On the equity side, it can mean moving away from the bias toward Canadian equities. It can also mean investing in non-traditional assets—such as real estate, infrastructure and commodities—buying them through exchange-traded funds to ensure liquidity, ease of investing and cost savings.
“In assessing target-date funds, one of the first things you have to consider is the glide path,” West explains. Such funds are evolving from a simple, linear glide path (say, a shift of 10% every decade toward fixed income) to a complex one in which there is more aggressive investing in equities in the early years and more aggressive reallocation toward bonds in the later years. “There is a lot more work going into the design of these glide paths and figuring out the optimal split between fixed income and equity at any point in time.”
West emphasizes that the retirement funds industry has to adopt an income replacement perspective. “If the goal is that an individual starts in this plan 40 years prior to retirement, is [the fund] getting that individual to where you want them to be at the maturity date?”
Pond views TDFs as a one-size-fits-all compromise. “They help somewhat,” he says, citing the rule of thumb that investors should be more aggressive when they’re younger and less aggressive as they move closer to the de-accumulation phase. Even at retirement, though, it’s quite common for 30% of a plan’s portfolio to be in equities, he notes. Further de-risking could be achieved by shifting entirely to fixed income assets. “However, if you built a retirement plan predicated on needing a 5% return every year, bonds won’t do that.”
Pond adds that insurance companies have introduced guaranteed products that lock in the principal of the investment. The Sun Life Financial Milestone Series of Segregated Funds, for example, features a guaranteed unit value at maturity. “As members edge closer to retirement, those sorts of products are definitely worthy of consideration,” he says. The fund managers typically buy long-term strip bonds to implement the guarantee. (A strip bond pays no interest throughout its term but entitles the holder to the full face value at maturity.) With this strategy, 100% of the fund is not invested in strip bonds—only the percentage required to guarantee that the fund does not go down in value. The rest is invested in options or futures to try to earn a higher return. These guaranteed products use derivatives to try to deliver a larger return, but they have a base return that is at least the amount currently in the member’s fund. Pond explains: “The products reset from time to time. If the values go up, they lock in that additional value, and that becomes the guaranteed amount.”
However, he notes, the security of the guarantee comes at a cost. “You’ve got to figure out whether the cost is worth it. If the risk is the risk of losing money, these are riskless products. But, again, if you have a model that’s predicated on earning a 5% annual return, on average, they’re not guaranteeing that—so they’re not riskless from the point of view of achieving that objective. It all depends what you mean by risk.” And how big a blip risk is on the plan sponsor’s—or member’s—radar.
Saskatchewan’s Public Employees Benefits Agency
Ann Mackrill, executive director, pension programs
Since 2007, Saskatchewan’s Public Employees Pension Plan (PEPP) has offered members a choice of one of six asset allocation funds, as well as a short-term bond fund. (The Public Employees Benefits Agency administers PEPP.) The default asset allocation fund, known as ST EPS, has 25% of PEPP’s 30,000 active contributors. It has 12 steps, moving from a growth-weighted portfolio toward a fixed income-weighted portfolio by five-year age intervals.
Investment consultants who reviewed the plan two years ago concluded that it “went too conservative too quickly,” says Mackrill. “Members need to have a higher proportion of growth assets in their fund a little longer so that they have the opportunity in the long term to grow their account balances.” So last November, PEPP changed the age bands.
The maximum equity weighting, 85%, was previously for members under age 20 but now applies to members under age 30. The maximum bond weighting, 70%, was previously for members age 70-plus but now is not reached until age 80. (Though similar to a target-date fund, the STEPS fund does not have members pick a retirement date.)
The other five asset allocation funds correspond, in their weightings, to specific five-year age bands along the STEPS continuum. PEPP provides a tool with which members can assess their risk tolerance and decide which fund suits them. “For members who are uncomfortable making investment decisions, that profile points them to STEPS,” says Mackrill.
PEPP’s next move is to introduce more diversification within its asset classes. “We’re trying to have managers who will offset [one another] in style and geography, in an attempt to reduce volatility,” adds Mackrill, noting that this measure should be in place by late next summer.
Sheldon Gordon is a freelance writer based in Toronto. netmon@rogers.com
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